Ken Taubes is Chief Investment Officer, US.
We believe inflation is rising more quickly than many appreciate, and that the Federal Open Market Committee (FOMC) risks falling behind the curve. Inflation, including wage inflation, is trending upward in an environment with little labor market slack.
Source: Year-over-year monthly percent change. Bloomberg. Last data point 2/28/17.
Driven by a doubling of oil prices, headline Consumer Price Index (CPI) has risen over the past year from 1% to its current 2.7% level. The major components of shelter and healthcare have risen even more at 3.5% and 3.4%, respectively. Personal consumption expenditures (PCE), the preferred inflation measure of the Federal Reserve (Fed), has risen to 2.1% year-over-year through February, up from 1.6% in December. Prices have not only risen on the consumer side; on the industrial side, the Producer Price Index (PPI) increased 3.7% year-over-year in February, versus negative 2.0% year-over-year in February of 2016.
Inflationary Pressures Reflected Globally
These inflationary pressures are echoed globally. Global inflation, reflecting higher energy prices and depreciating currencies relative to the dollar, is rising along with US inflation.
Inflation Rebounding in the US and Abroad
Source: Bloomberg. Data as of 2/28/17 except Japan and Canada, which are as of 1/31/17.
Trends in wage inflation, a key inflation measure for the Fed, continue to underperform expectations. Although unemployment has fallen to 4.7%, meeting the Fed’s definition of full employment, wage inflation has remained subdued relative to past recoveries. We believe that wage inflation may be poised to increase markedly in 2017 should monthly payroll gains continue to exceed trend labor force growth and the unemployment rate fall to 4.5% by year-end. Bianco Research has projected that average hourly earnings could reach 3.5% by January of 2018, based on its model that incorporates NFIB wage data, labor slack, manufacturing growth and consumer sentiment.
With economic and inflation data having generally surprised to the upside recently, the Fed has recently announced its first of three projected rate increases for 2017.
A Range-bound Dollar
A more positive economic outlook and rising inflation may lead to more hawkish Fed policies, which may support the dollar. Even though Trump’s tax reform and fiscal stimulus may not contribute to US growth until 2018, their projected benefits may also be dollar-positive. Furthermore, increased political risk in Europe, with the potential for populist victories in upcoming elections in France and Italy, and continuing capital outflows from China in the wake of declining growth and a weaker yuan, may help the dollar.
However, it seems more likely that the dollar will trade in a range due to offsetting factors, including the potential for tighter global central monetary policy, and the possible negative impact of Trump’s trade policies. Other central banks may choose to reduce quantitative easing, in light of higher global growth and inflation. In addition, Trump appears to believe that the dollar is overvalued, having complained about the US trade deficit and that major trade partners – such as Mexico, Germany, Japan and China – have unfairly depreciated their currencies to gain trade advantage. While proponents of the border-adjustment tax believe that any negative impact on US importers will be offset by a higher dollar, others believe that Trump’s trade policies can invite retaliation, and may ultimately hurt the status of the dollar. Finally, the proposed tax repatriation involving more than $1 trillion of cash held offshore may have muted effects on the dollar, since it is believed most of that cash is already held in, or hedged to, dollars.