Investors are warned: we are only one or two economic report cards away from a potentially devastating reassessment of the global economic and financial market outlook.
This reassessment would entail a much earlier and more aggressive than expected rise in US interest rates. Whether that would also entail a higher US dollar remains to be seen, as history suggests that if enough investors get spooked, capital flight from the US economy during a rate hike cycle can actually cause the US dollar to fall.
What we do know, however, is that equity markets would have nowhere to hide. With US earnings already under downward pressure, the prospect of higher US interest rates and an even deeper slowing in the US economy would not be great news.
So what economic report cards am I talking about? It’s not US housing starts or durable goods orders. In fact, it’s got nothing to do with the activity side of the US economy at all.
Rather, what I’m talking about is the inflation side of the US economy. The most critical economic report cards on the world’s largest economy over the next few months related to both wages and consumer price inflation.
Let’s recall that the last two US core (excluding food and energy) consumer price index readings have surprised on the high side, with monthly gains of 0.3%. As seen in the chart below, core annual CPI inflation has pushed up to 2.3% by February, and is now broadly in line with its average level in the low inflation era since the mid-1990s.
The Fed’s preferred inflation measure – the personal consumption expenditure (PCE) deflator – has also pushed up of late after excluding food and energy. At 1.67%, core PCE annual inflation in January was still somewhat less than core CPI inflation – but then again it usually is.
The Fed has said it would like to see PCE inflation at around 2%, but I’ve never understood why. After all, it has averaged considerably less than 2% over the past two decades.
Either way, excluding the sharp recent declines in oil prices – which, after all, are still a net benefit to the US economy – the US hardly has a deflation problem. In fact, it’s on the verge of having a good old fashioned inflation problem.
It’s not hard to see why. For starters, wage growth has also been picking up of late. After holding at not much more than 2% over recent years, annual growth in private sector average earning reached 2.6% in December, though has recently eased back to 2.2%. With the unemployment rate down to 4.9%, however, worker bargaining power is clearly increasing, and it would not surprise were there to be a few more uncomfortable wage outcomes in coming months.
Of course, wage growth would not be so bad if worker productivity were strong. But for much of America’s feeble economic expansion since the financial crisis, productivity growth has been lousy – with relatively strong employment growth despite weak output growth.
Over the past year, output per worker has lifted by only 0.5%, compared with a long-run average rate of 2%. Unit labour costs are growing at 2%, which is broadly in line with their long-run average – again hardly a sign the US is suffering from a deflation problem.
At the micro-level, strength in the housing sector is lifting shelter costs, while a levelling out in the US dollar after last year’s strength has seen a rise in imported goods prices. Medical costs also keep rising in America’s largely unchecked private health care sector.
In defending the decision not to raise interest rates last week, Fed chairperson Janet Yellen could not avoid noting that recent inflation reads have been on the upside, yet she still clung to the view that this might only be temporary.
That may be so, but after a long expansion which was given workers renewed bargaining power without lifting their productivity, America might be due for some lift in inflation.
If so, the Fed will have no choice but to act, even if Wall Street pleads for mercy.
Investors would be wise to keep a very close eye on US wage and price inflation indicators over the next few months.