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Fed Chair Janet Yellen’s testimony last Wednesday surprised the markets a little in its dovishness. Yellen does not expect that rates will need to rise very much from here before reaching their ‘neutral’ level. Furthermore, she remains cautious on inflation, adding that the committee ”will be monitoring inflation developments closely”. Friday’s CPI numbers demonstrated that her caution and close attention are warranted. The dollar was already on the back foot after Yellen’s somewhat dovish tone on Wednesday, but the inflation data sent the greenback to the ropes. CPI was flat month on month in June compared with May, and the annual rise in inflation fell yet again to just 1.6% in June from May’s 1.9%.
We shall not learn what June’s change in the PCE price index – the Fed’s preferred measure of inflation – was until the end of this month, but May’s figure was only 1.4% and if June’s CPI data are anything to go by, we can expect the PCE price index to fall to close to 1% when the June number is announced. This would leave it uncomfortably low relative to the 2% target and thwart the Fed’s rate-hiking ambitions. The FX markets were quick to pick up on the reduced probability of another rate hike this year (now only 44%), sending EUR/USD up to 1.1471 and GBP/USD to 1.3113.
Yellen is fond of attributing the lack of inflation in the US to temporary phenomena such as the price war amongst mobile phone service providers and an apparent one-off fall in prescription drug prices. She may yet be proven correct, but there seems to be more afoot than such one-offs.
An important, if not the most important, factor in explaining the lack of inflation in the US is the state of the labour market. Unemployment, at just 4.4%, is already well below the 5% to 6% level that has traditionally been viewed as the lowest level of unemployment that can be experienced without leading to wage pressures and an increase in general inflation. This is known as the ‘nonaccelerating inflation rate of unemployment’, or NAIRU, and it is subject to change over time.
NAIRU must certainly be lower than at any point in the last 50 years or so, otherwise, by definition, at this low level of unemployment, inflation would be accelerating instead of falling. Economists refer to this fall in NAIRU as a ‘flattening of the Philips curve’ – the graph that shows the inverse relationship between unemployment and inflation. We shall find out before too long whether the Philips curve has indeed substantially flattened in the US, meaning that the current very low levels of unemployment will not lead to increased wage demands and cost-push inflation – or whether Janet Yellen is correct and inflation is being temporarily depressed. However, it seems unlikely that the Fed Chair is entirely correct.
One of the main reasons for Donald Trump’s victory was the anger amongst white, blue-collar workers at the fall in real wages they had experienced over decades. Globalisation has meant such workers now find themselves immersed in a much deeper pool of competition and, in the language of Warren Buffet, there is no longer a protective ‘moat’. The jobs are there, as the low unemployment rate suggests, but the quality of the jobs is a different matter.
The debate about NAIRU and the Philips Curve is far from merely academic – it has very practical implications. In last week’s testimony to Congress, Yellen once again stated the FOMC’s desire to begin to reduce the Fed’s QE-bloated balance sheet later this year. As ex-Fed Chair Ben Bernanke has pointed out, markets would feel a great deal more comfortable if the Fed normalised interest rates before reversing QE. At least then, if it all went wrong, the Fed would be able to cut rates. Yellen, on the other hand, seems hell-bent on starting to reverse QE (albeit at a very gentle initial pace) later this year when rates will still be comfortably below 2%.
Given that the Fed has historically needed to cut the funds rate by an average of about 400 basis points to counter a recession, this seems somewhat courageous. It also means she had better be right about the temporary nature of the recent fall in inflation; otherwise, the Fed will end up giving the US economy a double dose of tightening at precisely the wrong moment. As JP Morgan Chase Chairman Jamie Dimon said last week on the subject of unwinding QE, ”we act like we know exactly how it’s going to happen and we don’t.“. Indeed.
Perhaps, however, Yellen has no choice. If the Fed followed Bernanke’s advice and waited until rates had reached an equilibrium level of, say, 3% before starting to taper the re-investment of bonds, bond yields, assuming a positive yield curve, would be higher still and the Fed would be facing huge losses across its QE portfolio.
Much of what is happening in the States is also true of the UK. The big difference of course is that while US policy makers fret about whether the recent falls in inflation will be temporary, in the UK it is the temporary – or otherwise – nature of recent rises in inflation that provokes debate. At least falling inflation in the US means that real wages are rising, whereas in the UK the opposite is true. The MPC has often been criticised in this Bulletin for presiding over ever higher negative real interest rates, as monetary policy has been left unchanged in the face of rising inflation. Perhaps we should give the committee members the benefit of the doubt. After all, with CPI at 2.9%, and average earnings rising at 1.8%, real wage growth is minus 1.1%. Using the higher RPI measure of inflation (still used for index-linked gilts and rail fares), which currently stands at 3.7%, puts real wage growth at minus 1.9%. This is already dampening consumers’ spirits and, despite the MPC’s latest 5-3 split, means the market views any sort of tightening this year as only a 50% probability.
Tomorrow sees crucial UK inflation data. CPI is expected to have remained at 2.9% in the year to June, compared with May. Meanwhile, RPI is expected to have slipped a notch to 3.6%, while the rate of increase in manufacturing input prices is expected to have dipped from 11.6% to 9.4%, as the shock of sterling’s post-referendum fall unwinds. More light will be shone on the extent to which negative real wage growth is impacting the consumer when retail sales data for June are released on Thursday. These are expected to show the year-on-year rate recovering to 2.5% after May’s very weak reading of 0.9%.
The ECB meets on Thursday. With the final CPI and core CPI figures having come in as expected this morning at 1.3% and 1.1% respectively, no change is expected to policy but Draghi’s post-meeting press conference will be very closely followed. As Brexit talks recommence this week, sterling is set to cement last week’s gains on the back the government’s statement to the effect that the UK will fulfil its financial commitments to the EU – hence reducing the chances of a hard Brexit. In the meantime, we can look forward to the parliamentary recess on Friday which should at least reduce some of the interminable Tory in-fighting of recent days.
All views expressed here are the author’s own and are based on information and data available at the time of writing
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