The vexing issue of inflation
The vexing issue of inflation
Central banks and investors are grappling with uncertainty about the future of inflation
Last week saw a focus on the topic of inflation. The minutes from the most recent Federal Open Market Committee (FOMC) meeting, released last week, showed that a number of FOMC participants are rethinking whether current low inflation is as transitory as they originally posited. The minutes even showed that a few FOMC members were interested in postponing future rate hikes until they are confident inflation is on a trajectory toward 2%. It seems that the Fed is still trying to understand why the Phillips Curve1 is no longer holding — why unemployment can hover around 4% but not drive up wage growth and, with it, overall inflation.
The minutes from the most recent European Central Bank (ECB) meeting were also released last week. They show a central bank whose Governing Council is confident about a strengthening of economic growth — but not as confident about the prognosis for inflation. After all, even though economic growth has improved significantly in recent months, the euro area rate of inflation is currently just 1.4% year over year — which is below the long-term average (since 1991) of 1.98%.2
The ECB’s uncertainty about whether inflation can rise sustainably is reflected in its desire to keep the conclusion of asset purchases open-ended: According to the meeting minutes, asset purchases will continue “until the end of September 2018, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim.” Underscoring uncertainty about the future of inflation, several members of the Governing Council actually suggested that there be a de-linking of tapering plans from inflation.
Investors seem to be concerned about inflation, but inflation seems unlikely
With inflation seemingly low and the Phillips Curve relationship being called into question in a number of economies, it seems surprising that we are seeing significant flows into Treasury Inflation-Protected Securities (TIPS). Last week, $1.2 billion in flows went into mutual funds and exchange-traded funds focused on TIPS.3 This was the third-largest weekly inflow on record. It seems that some investors are suddenly becoming concerned about inflation — the $64,000 question is why.
Actual inflation readings and inflation expectations in a variety of different economies remain low. In fact, Federal Reserve Chair Janet Yellen has started to question whether low inflation may be more than temporary; she explained in an address at NYU Stern School of Business last week, “My colleagues and I are not certain that it (inflation) is transitory and we are monitoring inflation closely.” And recall that, in the past decade, as very accommodative monetary policy was implemented, some economists worried that inflation would pick up — but that didn’t happen. With monetary policy becoming slightly less accommodative, it seems higher inflation is even less likely.
Perhaps concerns about higher inflation could be a result of the de-globalization trend we are seeing in different parts of the world. Consider an Organisation for Economic Co-operation and Development (OECD) paper from 2008 titled “Globalisation and OECD Consumer Price Inflation.” The paper argues that the moderation in inflation experienced in the 1990s and the 2000s was a result of a “marked increase in the extent of globalisation.”4 Other papers have made similar arguments, offering compelling reasons why globalization contributed to lower inflation. If globalization drove down inflation, then it stands to reason that de-globalization could drive up inflation.
And de-globalization seems to be afoot, which could be worrying for investors. For example, there is the distinct possibility the United Kingdom will leave the European Union (EU) without a trade agreement with the EU — a critical trading partner. And North American Free Trade Agreement negotiations have been extended into the first quarter of 2018 in an effort to keep this significant trade agreement alive — but odds seem to be increasing that it will falter. Then there is the US’ stance on trade agreements in general — an eschewing of multilateral trade agreements such as the Trans-Pacific Partnership in favor of bilateral trade agreements.
It could be that investors are expecting a rise in inflation over the longer term, driven by the powerful trend of de-globalization — or at least they may want to hedge against that possibility. Now, a week’s worth of flow data regarding US investors is far from conclusive — especially since bond markets don’t seem to be reflecting any inflation expectations, which is arguably why the yield curve has been flattening. However, recent flows into TIPS could be the proverbial canary in the coal mine, and so inflation, inflation expectations and de-globalization developments are all certainly worth close monitoring. And, given the trend toward de-globalization, investors may want to think seriously about how they can hedge against inflation in their portfolios.
1 The Phillips Curve is the theory that inflation and unemployment have an inverse relationship.
2 Source: Eurostat; data as of Oct. 31, 2017
3 Sources: Bank of America Merrill Lynch and EPFR Global
4 Source: Nigel Pain, Isabell Koske and Marte Sollie, “Globalisation and OECD Consumer Price Inflation,” OECD Economic Studies No. 44, 2008/1