February 28, 2018
Inflation is expected to rise this year on the back of a stronger economy, but investors need to consider whether the trend will be benign or harm the value of stocks and bonds, says Greg Ip, chief economics commentator at The Wall Street Journal.
“Unemployment at today’s low levels has over the postwar period typically coincided with rising price pressure,” Ip says. “A big tax cut and a federal-spending boost are about to juice the economy and potentially push unemployment even lower. Meanwhile, a falling dollar and rising oil prices are feeding through to other costs.”
Unemployment was at a 17-year low of 4.1 percent in January, while inflation was 2.1 percent, driven by a jump in gasoline prices. When stripped of volatile energy and food prices, the consumer price index was up 1.8 percent from a year earlier.
Political pressures to impose tariffs on foreign goods like Chinese steel or aluminum may also lead to higher consumer prices, Ip said.
The U.S. Commerce Department this month recommended imposing quotas on incoming shipments of the industrial metals, including a tariff of at least 24 percent on steel imports from all countries. President Trump has until April 11 to announce a decision on steel imports and until April 19 for aluminum.
“Protectionist pressures are mounting: Americans can expect to pay more for washing machines and softwood lumber and perhaps soon anything containing steel or aluminum because of tariffs imposed by President Donald Trump,” Ip said. “Productivity growth, the usual antidote to rising costs, is tepid and could stay that way.”
While many Wall Street economists aren’t too worried about inflation, there are scenarios in which prices could jump higher, as they did in the 1960s and 70s.
“In 1966, inflation, which had run below 2 percent for nearly a decade, suddenly accelerated to over 3 percent,” Ip says.
At that time, unemployment had fallen to 4 percent while President Lyndon B. Johnson approved more spending for the Vietnam War and “Great Society” social programs. The federal deficit ballooned to more than 2 percent of America’s yearly economic output, similar to what is expected today with Trump’s tax cuts and a deficit of more than $1 trillion.
The Federal Reserve, under the leadership of former chairmen William McChesney Martin Jr. and Arthur Burns, made a major policy error by keeping interest rates low with the expectation that unemployment could fall even further.
“From 1966 to 1981, inflation and interest rates climbed to double digits, decimating stock and bond values,” Ip says. “Inflation doesn’t have to top 4 percent, much less 10 percent, to wreak havoc: a world in which inflation risks persistently point up instead of down would drive bond yields higher and kick the support out from under stock and property values.”
Today’s worry is that President Trump will pressure Fed Chairman Jerome Powell, who succeeded Janet Yellen this month as head of the central bank, to keep rates too low for too long as a way of driving the stock market higher.
“So far, this seems unlikely: Mr. Trump and his officials have asserted the Fed’s independence and no central banker, Mr. Powell included, wants to be remembered as another Arthur Burns,” Ip says. “But if you had given inflation up for dead, it is prudent to consider the consequences if it turns out to have only been sleeping.”
Powell yesterday said his outlook for the U.S. economy had strengthened since December on signs of better wage growth and inflation. He spoke in regularly scheduled testimony to the House Financial Services Committee, his first appearance on Capitol Hill.
Powell also said he “wouldn’t want to prejudge” whether Fed officials would schedule four interest-rate increases this year instead of the three they forecast late last year.
Larry Kudlow, the Reagan administration economist who advised the Trump campaign on fiscal policy, said he was encouraged by Powell’s comments about consulting monetary policy rules to help set interest rates.
A rules-based approach makes Fed policy more predictable for investors, especially in the context of the Taylor rule, a guideline developed by Stanford economist John Taylor for setting interest rates in relation to inflation and measures of economic slack.
“I’ve never seen that in any testimony before,” Kudlow said on cable channel CNBC. “Monetary rules — that is new for the Federal Reserve, and I think that’s progress.”
The Taylor rule suggests that the Fed’s short-term target rate should be double its current level, Jack Ablin, chief investment officer of Cresset Wealth Advisors in Chicago, said on CNBC. The Fed Funds rate is currently about 1.25 percent to 1.5 percent, the highest since the financial crisis of 2008.
Kudlow also praised Powell for expressing a hands-off approach to the market. One major criticism of the Fed is that it has distorted the market process of price discovery that helps to measure investor perceptions of risk.
“He’s very market-oriented, and I like that very much,” Kudlow said. “I think we need someone like that, very pragmatic-minded.”