Henny Sender: US recovery rouses inflation concerns

It cannot be a good idea to begin a column by parsing the utterances of the Federal Reserve’s open market committee on the subject of inflation. But the combination of a delicate shift in emphasis on this matter and the news this week that the US economy grew 4 per cent in the second quarter has dramatically altered the investment calculus on Wall Street.

At least for the moment, the optimistic view that the US economy has finally reached take-off velocity prevails. Now the challenge for investors is to determine whether that view will endure, although it should be pointed out that, on average, the US growth rate remains barely more than 2 per cent – as it has for the past five years.

“Our base case remains that 2014 marks the beginning of the end of the post-global financial crisis era as stronger US-led global growth finally induces a ‘good’ rise in interest rates and a ‘safe’ departure from this weird world of Maximum Liquidity & Minimal Volatility,” wrote Bank of America Merrill Lynch chief investment strategist Michael Harnett in a research note the following morning.

“Higher US growth, higher US yields, higher US dollar and ultimately a modest normalisation of monetary policy will not lead to lower growth and/or a financial shock.”

Mr Harnett adds that he detects a shift from “leaders” such as the high yield market to the “laggards”, which include the Chinese and Japanese markets.

Many hedge funds clearly believe that to be the case. Two of the most popular hedge fund trades these days are to take bearish views on US rates and to buy Japanese shares. (Although a big part of the latter positioning is to front run the massive government pension fund, which has announced its intention to increase its exposure to the stock market now that the Bank of Japan is buying up most of the government bonds.)

In the wake of the two developments, 10-year Treasury bond yields rose 9 basis points to 2.56 per cent while the Nikkei increased to a fresh six-month high.

The sunny view gathered conviction with the Fed’s nuanced change in language that inflation “moved somewhat closer to the Committee’s longer run objective” rather than that “inflation has been running below the Committee’s objective”.

So the second task for investors is to ascertain whether that inflation will be the good sort or the bad sort, and whether inflation is better than deflation.

Economists and central bankers dislike and fear deflation because there is little they can do about it. The deeper deflation, the less effective monetary policy becomes. Meanwhile, bankers loathe it because the burden of repaying the loans they extend becomes heavier in a deflationary environment. But for others, deflation can be more benign. There are good deflationary scenarios, for example when prices fall because of gains in productivity or innovation while wages remain stable.

The same dynamic is true for inflation. The problem today is that the US risks falling into the bad kind of inflation whereby prices rise while wages fail to keep pace. The big support for economic growth these days has been consumption (real consumer spending rose 2.5 per cent for the quarter) but household spending depends on purchasing power and that depends in turn on compensation.

That is why the Fed is so concerned with the health of the housing market and the labour market. As long as there “remains significant underutilisation of labour resources”, in the words of Fed chairwoman Janet Yellen, the workforce has little pricing power. Wage growth has picked up only modestly, according to recent data.

Japan, meanwhile, seems to be suffering from the wrong kind of inflation, which stems from the rising cost of energy and other imports. Meanwhile, in June, total cash earnings of Japanese salarymen were down 3.8 per cent in real terms year over year, notes Chris Woods of CLSA.

During the three years 2004-06, one former Fed official noted that a full 3.5 per cent of GDP came from households using their homes as ATMs, borrowing (and spending) against the equity they had in those homes. Once that game ended, “I knew growth would be lower”, this official recalls.

Even if the optimistic scenario holds true today, it is possible that it will not be true tomorrow. For that to happen, the housing recovery must surmount higher rates. Labour needs to improve productivity and receive a greater share of corporate profits. The government needs to take advantage of current interest rates and a smaller budget deficit to start spending on things like education and infrastructure to make economic growth more sustainable. But what is so clearly sensible seems as elusive as ever.


Henny Sender


Fonte: FT