Inflationary Amber Alert

January 13, 2017

After the election of Donald Trump, the dollar, U.S. equities, long-term interest rates, and commodities rose initially. Some of these changes have been pared, but they reflect a changed perceived economic outlook. Analysts who follow fundamental economic trends became more optimistic about economic growth and the likelihood of higher inflation. Market players were very mindful that a combination of tighter monetary policy and loose fiscal policy in the early 1980s was associated with a doubling of the dollar’s value.

The case for higher inflation appears more compelling than that for stronger real economic growth. There are already signs of a rise in inflation. The labor market has tightened. Unemployment is below 5.0% compared to a former cyclical peak of 10%, and on-year average hourly earnings growth of 2.9% in December was the highest in years. Oil prices are well above previous lows, and inflation has picked in many countries besides the United States. Increased U.S. tariffs are going to be imposed to discourage U.S. firms from having productive facilities abroad and to penalize countries that the new administration feels are using unfair trading practices. Whether or not such achieve their desired goals, they will make goods sold in the United States more expensive. Finally, U.S. short-term interest rates are negative in real terms. It will be quite a while longer before the federal funds rate is as high as inflation.

The case for significantly stronger economic growth is more dubious. Growth is dependent upon the size of the labor force and the productivity of workers. Employment growth has actually been quite robust, but an acceleration of that pace is constrained by shortages of needed skills. Productivity has been very weak. Corporate investment has been weak, and the push for device mobility and social networking hasn’t produced the kind of productivity burst spurred by personal computers and the internet. This will take time, if at all,  to gather ample steam. Deep tax cuts and deregulation in George W. Bush’s first term failed to deliver fast growth, and political instability can exert a toxic influence on growth.

It’s been a long time since the United States had a perceived inflation problem. Consumer prices on average rose 1.7% per year over Obama’s two terms, 2.4% per year in the eight-year presidency of Bush43, and 2.6% a year when Bill Clinton was president. Collectively, that covers an entire generation, and memory over such a long span can become fuzzy. Conventional wisdom now perceives the inflation problem as confined to Jimmy Carter’s stewardship, and that is when it got so bad, averaging 10.4% per year, as to dwarf all other economic problems.

But inflation didn’t spring from nowhere, having averaged 6.4% per year during the eight years of the Nixon/Ford stewardship. Under the eight years of Kennedy/Johnson, consumer prices had risen on average just 2.2% per year, so the average acceleration between their pace and that associated with Nixon/Ford was just as great as between Nixon/Ford and Carter. The long battle to reduce inflation to desired levels is better remembered that how long it took for inflation to get so bad that little else in economic performance mattered much.

History is never a perfect guide to what lies ahead. While some elements of the present may seem similar to times in the past, other developments are new or more pronounced. The polarization of income and wealth was comparatively new and much less extreme than now during the presidencies of Reagan and even Bush43. Reagan inherited a 7.5% unemployment rate, as did Carter before him, and Clinton started with unemployment similar at 7.3%.

The dollar performed poorly in the 1970s under Nixon, Ford and Carter. When inflation fell sharply in Reagan’s first term, it did very well. The dollar advanced during the deep recession of 1981-82 but was bashed during the recession of 1973-75 when inflation was a rising problem. Not in recent memory has U.S. inflation created selling pressure on the dollar. Restored faith in U.S. monetary policy actually flipped the dollar response to higher-than-expected inflation because of market confidence that price stability would be restored with tighter monetary policy.

A combination of faster and more inflationary U.S. growth seems a recipe for a stronger dollar. The result of faster inflation but only steady growth is more ambiguous.




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