US inflation and recession scares

No basis for upsurge in US inflation or recession despite market jitters

Mar 20, 2018 | John Greenwood

Recently there has been an inflation scare in US financial markets. When the monthly labour market figures for January were released in early February, the reported 2.9% rise in average hourly earnings triggered a sharp sell-off in equities and a rise in bond yields. Equities and bonds have not yet recovered from that shock. But how valid is the threat of an upsurge in inflation?

False Theories of Inflation (1) Fiscal Expansion
A year ago, there was concern that a large increase in the US budget deficit as a result of President Trump’s plans to cut taxes and increase infrastructure spending would cause rising inflation.

However, this view is misguided. On a previous occasion when there was a significant cut in US taxation and rise in government spending – during President Reagan’s period in office – the federal deficit rose from 1.3% of GDP in 1980 to 5.9% of GDP in 1986. However, far from increasing, the inflation rate plummeted – from 14.8% in March 1980 to just 1.1% in December 1986. That was due to the tight control of money growth implemented by Fed Chairman Paul Volcker. The lesson is that without faster growth of money and credit, increased fiscal deficits will not bring higher inflation.

However, China’s fiscal stimulus of 2008-09 is often cited as an example of successful fiscal stimulus. Briefly, RMB 4.0 trillion of fiscal spending (equivalent to US$ 586 billion) was announced in November 2008, but the central government would only provide 1.2 tn yuan of funds. The rest was to come from provincial and local governments. However, these organizations did not have sufficient funds, so they turned to the banks, often creating Local Government Financing Vehicles (LGFVs) for the purpose. The result was that M2 and bank credit surged from growth rates of around 15% p.a. to peaks of 30% and 34% respectively, or an average growth of 25% growth over two years. In other words, China’s spectacular recovery was based at least as much on monetary expansion as on fiscal expansion.

More fundamentally, the key point is that inflation is a monetary phenomenon, and therefore it will only rise after a sustained period of faster money and credit growth. Moreover, inflation should be seen as a part of the business cycle which itself is a monetary phenomenon.

False Theories of Inflation (2) The Phillips Curve
A second misguided view of inflation relates to the Phillips curve. A “typical” Phillips curve relationship sees wage inflation rising as the unemployment rate falls and feeding directly into overall price inflation.

In practice, the US “wage” Phillips curve has been almost flat in this upswing, and in the past couple of decades – as also in the UK, Germany, Japan and elsewhere.

In the case where there has been no acceleration of money growth, it does not follow that there need be any significant increase in the inflation rate. In most developed economies, there has been no sustained acceleration of money growth sufficient to cause a surge in inflation. Until there has been, it follows that inflation will remain low.

No basis for a recession
A second scare story in 2016-17 was an imminent US recession. Admittedly this idea has been less prevalent since the Trump tax cuts in December, but it was nevertheless promoted in numerous models of “recession probability” devised by economists at investment banks. In my view this idea is largely groundless.

First, the best indicator of an imminent recession in the US has been the inversion of the yield curve shown by the spread between the 10-year Treasury yield and the 3-month Treasury bill yield. Today the yield curve is far from inverted, and not likely to become inverted any time soon. The second indicator is a sharp slowdown in money and credit growth. In reality, US money and credit growth have been low and steady for several years.

A third indicator is the health of private sector balance sheets. Banks have been recapitalized, and are more liquid nowadays. Also, as regularly reported by the New York Fed, consumer balance sheets are in much better shape, so even if interest rates continue to rise, US consumers should be resilient.

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