The Federal Open Market Committee (FOMC) just tightened short-term rates by 25 basis points for the third time in the last seven months – resulting in a target range of 1.00% to 1.25%.
Beyond the Federal Reserve’s desire to normalize interest rates after a decade at crisis level lows, the most significant data driver of the FOMC’s action is the unemployment rate. Recorded at 4.3% for the latest release in May, the rate has punched through the Fed’s own most optimistic forecasts.
Source: FRED, 5/1997 - 5/2017, Shaded areas indicate U.S. recessions
As we are all aware, the Fed is model-driven, meaning their forward forecasts are influenced by historic events and mathematical formulations that extrapolate past experiences.
One of the more famous models is the Phillips Curve, describing the relationship between inflation and price levels. Named for A. W. H. Phillips, who studied unemployment and wage inflation in the United Kingdom from 1861 - 1957, the Phillips Curve plots an inverse relationship between the two that was consistent. When unemployment was low, workers being scarce, wages were able to rise. Alternatively, when unemployment was high, an abundant supply of workers made wage gains somewhat more difficult. It is a logical notion, and the data bore out the relationship.
The connection has frayed somewhat more recently. Notably, inflation has undershot expectations when unemployment has fallen. Today, the thinking around the relationship has been modified for a concept called the nonaccelerating inflation rate of unemployment (NAIRU). This figure is not a fixed number – it varies with technology, demographics, worker’s union power, and the tax structure. Further, NAIRU is also a function of those prices that are actually changing. But it does say that unemployment can decline to some (unknown) point, without accelerating inflation. The Fed, we surmise, thought NAIRU was about 5%. Yet the unemployment rate has dropped beyond that figure, given that it is now sitting at 4.3%.
While the economy recently witnessed core inflation pressing against the Fed’s 2% target range, recent data has shown it falling.
Source: FRED, 5/2012 - 5/2017
Officially, the Fed thinks the issue is transitory, or in their words “noisy”. Wages, in their view, will likely accelerate. In that case, hiking rates now just makes their job easier later.
Sitting somewhat against this view, economists have learned much more about the power of expectations – in particular, that individuals’ and firms’ own inflation forecasts influence their decisions. The net of this might simply be that once inflation forecasts have adjusted, the rate of unemployment might just be compatible with a range of inflation rates. This idea, of course, throws the Phillip’s Curve model on its ear.
So what is happening? Why is inflation not accelerating, given that a 4.3% unemployment rate must be indicative of scarce labor? Why is scarce labor not pressuring wages? The answer might be that several large forces which have been keeping inflation low might be expected to continue to do so. The assumption here is that businesses are not able to raise prices, and this may be dominating inflation expectations. In this regard, we see four forces that bear watching.
The first of these forces is represented by Amazon, which itself is an illustration (and likely the strongest example) of competitiveness driving down prices. The marked decline in other grocer share prices when Amazon announced a buyout of Whole Foods is indicative of the market’s acknowledgement of Amazon’s ability to compete on price. The price drops of those shares indicate a risk that their earnings will be lower. Both Barnes & Noble and Borders booksellers were leading indicators. Beyond these glaring examples, the economy is rife with patterns of competitiveness continuing to create slack – lack of pricing power – in the economy. Every company wants your business, and they will compete on price to obtain it.
Technology is a factor at play in this price competitiveness, but predominantly a driving force itself. Smart phones, the cloud, robots, and much more are relentlessly pushing down costs. Uber would not exist without the mobile phone. That they do exist is much to the dismay of regulated cab drivers almost everywhere. Their use of technology is disruptive in that it changes previously successful business strategies, reducing their margins and presenting additional competition.
We are seeing an interesting phenomenon in commodity pricing, with oil epitomizing the trend. The majority of gains in oil supply are the result of advances in technology, with horizontal drilling having a meaningful impact. However, the inability of a seemingly more disciplined OPEC to maintain price is something new. Even with what is looking like a synchronized global expansion, with growth in Asia, Europe, and the Americas, oil has no pricing power. Given the role commodity prices typically play in driving inflation, we see this new development as quite significant.
A last reason is that globalization remains alive and well. It represents not only global customers, but also global suppliers. The ability to source labor or capital goods almost anywhere on the earth adds capacity, while the requisite slack limits pricing power.
So where is inflation? We believe these four forces are the reason it appears to be missing in action.
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