Inflation is not on the radar anymore. We do hear occasional comments from central bankers who warn about future inflation arising from QE. We also recall a few statements in the media along the lines of, “They’re printing all this money, we’re going to have huge inflation, and interest rates are going to shoot up.”
We have been on the low-inflation side of that debate for years. We have supported the argument that there is a huge overhang of surplus capacity in the global labour force and that inflation is not a problem when labour income is flat, falling, or not rising robustly. This coincides with a wounded credit multiplier and a damaged financial credit system, conditions that have existed for the last five years. They are gradually improving, but only gradually. They are conditions that cause deflationary pressures.
Will we have deflation? We are not certain. The forces at work globally that could bring on deflation are being blunted by the huge quantitative easing (QE) being undertaken by most major central banks.
Let’s take a quick look at the US. All important measures of inflation in the US are on downward trends. Many thanks to Credit Suisse’s Neal Soss and Jay Feldman for a recap of the data in their research note of May 17. They report Core CPI, Cleveland Fed Median CPI, Cleveland Fed Trimmed Mean CPI, Core PCE, and Dallas Fed Trimmed Mean PCE. All are trending downward, as measured on a year-over-year basis, and those trends are accelerating. Commodities are also on downward price trends. So are the more esoteric inflation measures like market-based indices and chained indices.
In the case of the Core PCE, which is believed to be the Federal Reserve’s preferred measure, the rate of inflation measured year-over-year is approaching one per cent. Remember that the Fed’s threshold for any change in monetary policy is two per cent. And Fed communications have suggested that a rate of 2.5 per cent would be the threshold for any action taken to alter QE for the purpose of improving the employment statistics. So we are a full point and half away from that threshold, and the trend is in the opposite direction.
The Fed’s stated unemployment threshold is 6.5 per cent on the traditional headline unemployment rate (U-3). The Fed has also talked about other elements in the employment statistics, suggesting that the U-3 unemployment rate is not the only target measure for restoring the US to a more robust recovery. The charts and graphs that we have posted on our website and released in speeches present the employment statistics in a variety of ways that may be useful.
Other measures, such as the U-6 broad-based unemployment rate, Beveridge Curve analysis, and the disaggregation of employment data, all point to a very large underutilized labour force in the US. The same seems to be true for most of the rest of the world.
Our conclusion is that inflation is not a problem now and is not likely to become a problem soon. In fact, if certain indicators of inflation continue to head downward, they could trigger a reaction by the Fed because the risk of deflation will be perceived to be rising.
Is deflation a threat today? The answer seems to be no. More likely, we are in a period in which the rate of inflation will be too low to be a problem and will gradually turn higher over several years as additional stimulative policies unfold worldwide.
Meanwhile, low inflation is a very healthy environment for the stock market. It means that inflation distortions in reports of earnings are nearly nonexistent. That implies that the quality of earnings reports is very high, since they do not contain the distortions that occur in accounting systems when inflation is high.
Higher-quality earnings justify higher price/earnings multiples and higher stock prices. There is a consistent linkage between very low inflation and very strong asset pricing. This is particularly so when interest rates are very low and likely to stay low for a very long time.
We remain bullish. Inflation statistics support that outlook. They also support a gradual change in the outlook for bonds. Eventually, bond yields will be higher, maybe much higher, but the process is a gradual one. That means some tactical hedging in bond portfolios is appropriate. Panic selling of bonds is not.