October 8. Looking down the inflation barrel
The recurring theme from Fed officials is that inflation is too low. Yellen is mystified. Brainard is concerned. Dudley thinks it will get back to 2% sometime soon. Bullard thinks the downside surprise in inflation in the first half of the year is unlikely to reverse. The Fed as a whole wants the public to believe it can magically reach the 2% target and keep it there, partially through managing expectations (a variation on forward guidance), yet various Fed officials openly fret that they don’t exactly understand the interplay of inflation dynamics. The problem is well known. Wages aren’t growing sufficiently. Capital expenditures haven’t been strong. However, on Thursday Philly Fed President Harker said “Lack of skilled workers is a top issue for the economy.” This comment was made at a workforce development conference, so perhaps it’s taken out of context, but the phrase “lack of” usually means “higher price”.
It’s pretty obvious that there has been inflation in equity prices, with all indexes making powerful new highs this week. But there are some other fairly clear examples of higher prices in the economy, shown in the charts below. The top chart is Prices Paid for both manuafacturing and service ISM released last week. Manufacturing prices paid (white line) is at the highest level since 2011, and for services (amber), it’s the highest since 2012.
But without labor price increases, inflation can’t really be sustained, right? Well, Friday’s employment data showed average hourly earnings at +0.5. Below is a chart of yoy average hourly earnings, at a new high of 2.9%. I have also included the Atlanta Fed wage tracker on this chart, which has been more volatile, but is still 3.4%. I’ve helpfully drawn a red arrow, just to clarify that the general direction is up.
So there it is, in black and white. For the Fed, maybe it’s getting close to the “Be careful what you wish for” warning. It’s like a Road Runner cartoon. Wile E. Coyote has packed the cannon with gunpowder (and then added more, just to be certain). The road runner is a fast approaching speck in the distance; Wile E. lights the wick. The sparkles fizzle just as the wick burns to the trigger and the road runner beeps and blurs by. The plan is a dud. The frustrated coyote looks down the cannon barrel to see what went wrong. KA-BOOM!
The Fed has loaded up the balance sheet with gunpowder. They lit the wick, announcing the onset of QE unwinding. Now they’re examining the inside of the inflation barrel. Obviously it’s hard to be right on timing. But IF the main depressant on inflation is wages, and IF a top issue for the economy is lack of skilled workers, and IF wage growth is back up to 2.9% and further converges to the Atl Fed level, then there’s the possibility that the 2% target isn’t a cap. Maybe it will blur right past.
Clearly, that outcome would be bearish for treasuries. But there are a couple of other concerns as well. One is, of course, fiscal spending related to clean-up for the barrage of storms. Second is the potentially stimulative effect of tax reform proposals. Also, the treasury this week released a blueprint for reforming regulations on capital markets. One of those changes includes relaxing margin requirements on swaps and another expands the definition of high quality assets included in the liquidity coverage ratio. At the margin, the implication is less demand for treasuries from a regulatory standpoint. [Link at bottom; summary on pages 210 regarding High Quality Liquid Assets, and 212 on Swap margins]. The eventual decline in the Fed’s mortgage holdings should also contribute to an increase in volatility on the longer end. For a long time, and even until now, the curve reflects little in the way of an inflation premium. 5/30 remains pinned to its recent low of 92, closing the week at 94. 2/10 closed at the high of the week, but is still only 86 bps. That situation may change.
This week includes auctions of 10’s and 30’s. Mnpls Fed’s Kashkari speaks, likely basking in the glow of having his name bandied about as a contender for the Fed Chair due to his unwavering dovishness. PPI Thursday. CPI and Retail Sales Friday.
**********************************************************************************
