On June 18, 2014, the Federal Open Market Committee (FOMC) voted to keep the federal funds rate unchanged at 0.25% and for the 5th consecutive meeting to reduce the pace of monthly asset purchases by $10 billion (bn) to $35bn. The tone of the statement and Chairwoman Yellen’s press conference was more dovish than expected. The market responded accordingly, as equities and 10-year yields rallied and the U.S. dollar (USD) sold off.
Despite the seemingly “Goldilocks scenario” for investors, we warn against complacency. First, we are concerned the Federal Reserve (Fed) is overlooking a real pickup in Consumer Price Inflation (CPI) and harbingers of wage inflation that are underway. Second, investors may be far too cautious about the Fed’s tightening cycle. The combination of these factors has the potential to create a turbulent market.
Inflation and Wages Gaining Momentum
The rise in inflation is real. After remaining fairly stable at low levels in 2013, inflation is gaining momentum in 2014. We analyzed trends in the key components of the inflation basket – food, transport, apparel, housing, medical care, recreation, education & communication and other goods & services. Our objective was to focus not on the current year-over-year (y/y) level of CPI and surmise the trend, but to determine the momentum. We found three interesting developments:
- Inflation is accelerating above 3% in food, housing and medical care, which comprise nearly 63% of the CPI basket (Chart 1).
- Seven out of eight components are on an upward trend with only one component in deflationary territory – transport. We do not think this is sustainable, as transport prices have turned positive on a year-over-year basis.
- Finally, overall CPI is accelerating sharply from a trough of 0.4% quarter-over-quarter (q/q), annualized in June 2013, to 2.4% as of May 2014.
Chart 1: U.S. Inflation On an Upward Trend Q/Q Annualized Growth Rate
The Fed is not Concerned
We remain puzzled at the Fed’s apparent lack of concern about inflation. This became clear early when the Fed used the former inflation and unemployment thresholds as an integral part of monetary policy, and it was apparent the Fed was willing to let inflation overshoot its 2% target by 0.5%. Notably, during the press conference, Yellen downplayed the recent pickup in inflation, saying “the data we are seeing is noisy.”
Wages are also Rising
During her press conference, Yellen stated that wage growth remained contained. On the contrary, the measures of wage inflation we monitor say otherwise. The National Federation of Independent Business (NFIB) Small Business Survey reports a sharp increase in businesses that have reported rising wages during the past 3-6 months (Chart 2). This pattern is consistent as the unemployment rate continues to fall. Also, wage growth in average hourly earnings for production and nonsupervisory workers picked up from a trough of 1.3% y/y in October 2012 to 2.4% y/y in May 2014. Barclays reports that this pace of increase is actually faster than recent historical experience might suggest. They highlight that the current pace of wage growth was not reached in the last cycle until the unemployment rate had fallen to 5.4%, consistent with the idea that the natural rate of unemployment or Non-Accelerating Inflation Rate of Unemployment (NAIRU), is higher now than it was then.
Chart 2: NFIB Small Business Survey – % of Companies Raising Worker Compensation
The Fed’s Misguided Focus
With the Fed dismissing the rise in inflation, it seems to place greater emphasis on wage growth. In fact, during the March 2014 FOMC press conference, Yellen cited an acceptance of wage inflation between 3 – 4%. So far, the Employee Cost Index and average hourly earnings have been well below Yellen’s “target.” However, we believe it is incorrect to target these wage inflation measures because this is a lagging indicator. According to a Bank of America analysis, in prior tightening cycles the Fed has been hiking rates 1-2 years before wage inflation hits 3%. They cite academic studies where there is a 1.5 – 2 year lag between unemployment and wage inflation. As many studies have documented, inflation is persistent. Thus, the Fed’s focus on wage inflation for the timing and pace of hikes can run the risk of falling behind the curve if similar lags and persistence exist today.
A Disconnect Between the Fed and the Market
There is a disconnect between Fed’s rate hike trajectory and market’s rate hike expectations. The Fed’s median rate forecast for 2015 and 2016 rose by 12.5 basis points (bps) and 25bps, respectively, compared to the March projections. However, the market is anticipating the first rate hike to be Q3 2015. This makes investors vulnerable to any stronger U.S. economic data or a change in the Fed’s current lackadaisical view on inflation.
We dismiss the surprisingly weak Q1 gross domestic product (GDP) report as backward looking and therefore outdated. According to Goldman Sachs and Barclay’s Q2 GDP tracker, the U.S. economy is currently expanding 4.0%. As the high frequency macroeconomic data continues to validate above potential growth (>3%), market concerns will inevitably shift from growth to the upward momentum in inflation and harbingers of rising wage pressures. We warn investors not to be complacent with U.S. 10-year yields hovering around 2.5%. It is only a matter of time before concerns over stronger macroeconomic data and inflation lead to a selloff in U.S. yields and finally push the USD higher on a sustainable upward trajectory.