Markets: The Fed Isn't Missing Signs of Stagflation
(Bloomberg View) -- Inflation has been so low for so long that any uptick prompts proclamations that the Federal Reserve has fallen behind the curve or worse. Last week, soft January reports on retail sales and industrial production and a strong reading on core CPI inflation led to alarm about stagflation, a dreaded combination of weak economic growth and sharp increases in consumer prices.
Investors should ignore these calls.
The appeal is understandable. After all, there are some similar historical episodes. In the mid-1960s, the U.S. government embarked on aggressive fiscal policy even though unemployment was low. Sound familiar? Policy makers could be misjudging the amount of spare capacity in the economy as they did in the 1970s, when that interpretation led to a period of overly loose monetary policy. Then, wage and price controls and a series of energy supply shocks likely took a toll on the supply side of the economy. Today, decisions to enact tariffs on some consumer goods and manufacturing inputs could do the same. Still, the differences between now and then are far more important.
For starters, it is important to not draw sweeping conclusions with just one month’s data. Consumer confidence has jumped to cycle highs, which isn’t consistent with plunging retail sales. Manufacturing employment and sentiment continue to climb, at odds with the recent slowdown in factory production. Indeed, for the most part, the current dataflow are not at all consistent with a stagflation environment. Unemployment is low, real growth has picked up and core inflation remains low.
The chart below plots the jobless rate against core PCE inflation during specific periods. It also divides the data into quadrants using 5 percent unemployment and 2 percent inflation as the dividing thresholds. For example, the 1960s can be considered an “inflationary boom” with low unemployment (defined as below 5 percent) and high inflation (above 2 percent). The 1970s saw high unemployment and high inflation, or stagflation. Today, the U.S. economy features low unemployment and low inflation. The last time it had anything close to what can be described stagflation was in early 2008.
During the 1970s, the Fed gradually lost credibility, always seeming to do too little, too late to stop inflation. The end result was a sustained increase of household inflation expectations. How companies and households feel about the future path of inflation has relevance for how actual inflation evolves. For example, how a worker feels about the future path of inflation may influence their position in wage negotiations with their employer. During the 1980s, the Fed’s credibility was restored as inflation expectations declined. Today, the good news is that household and business inflation expectations remain reasonably well-anchored. That no one expects an inflation breakout is one reason why it is unlikely.
In the 1970s, stronger union power was able to generate somewhat stronger wage gains than warranted by the gains in productivity, driving unit labor costs higher. Labor productivity was also quite strong in the 1960s, and so the workforce of that era may have had a somewhat inflated sense of what workers ought to be paid. Today, compensation growth is about where one would expect given the growth in productivity. And, in contrast to the 1970s, labor productivity is already coming off a long period of sluggishness and has shown signs of life in the last year. That productivity is not collapsing as it did in the 1970s is an important reason why an inflation breakout seems unlikely today.
Today, inflation risk is normal; deflation risks remain low given the improving economy and the tightening of the labor market. At the same time, the risk of an inflation breakout seems low given the stability of inflation expectations both at the household and company level. This should take some of the steam out of the recent increase in Treasury yields and provide some relief to U.S. equity investors.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Neil Dutta is the head of economics at Renaissance Macro Research, responsible for analyzing global trends and cross-market investment themes.
To contact the editor responsible for this story: Max Berley at mberley@bloomberg.net.
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