global perspectives

Inflation Risks Rise as US Economic Slack Erodes

Salman Ahmed, PhD - Chief Investment Strategist

Salman Ahmed, PhD

Chief Investment Strategist
Charles St-Arnaud - Senior Investment Strategist

Charles St-Arnaud

Senior Investment Strategist
Jamie Salt, CFA - Systematic Fixed Income Analyst and Portfolio Manager

Jamie Salt, CFA

Systematic Fixed Income Analyst and Portfolio Manager

Key points

  • There is more slack in the US economy than unemployment figures suggest.

  • Although this explains the lack of wage growth to date, spare capacity is now almost used up.

  • Misreading unemployment data has lulled many investors into a false sense of security regarding inflation, after years of expecting a pick up.

  • Our analysis suggests that we should start to see an increase in inflationary pressure in 2018H2.

  • An acceleration in price changes is likely to lead to faster-than-expected rate hikes and higher yields, in our view, with major implications across asset classes. 

In recent years, policymakers in many countries have been puzzled that inflation and wage growth have remained weak despite low unemployment. This unusual situation is particularly evident in the US, where the jobless rate is very low by historical standards and widely considered to be under the “NAIRU” – the “non-accelerating inflation rate of unemployment,” below which price and wage rises would be expected to pick up speed.

Many investors now seem to think that the Phillips curve, which plots the relationship between the unemployment rate and wage growth, no longer works. We believe that this view is wrong – and, moreover, that inflation remains one of the key risks to the US economy and could lead to a faster withdrawal of policy stimulus (see our ‘2018 Outlook: Big Bang or Steady State?’).

The source of misunderstanding, in our view, is that the unemployment rate is not the right way to measure of the level of slack in the US labour market. This matters: if the old inflation-model still applies – where inflation rises non-linearly as capacity constraints increase – policymakers could find themselves having to hike rates more rapidly than the consensus (something the New York Fed President has alluded to recently) with a significant impact on asset prices.

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