The USA is further down the path to normalised economics than any other developed country.
The labour market is tight with only 3.9% of the eligible workforce unemployed, wage growth is improving, and the combination of President Trump’s recent fiscal stimulus and tax cuts are set to support further growth in the US throughout 2018 and 2019. Consistent with this growth is the expectation of rising US inflation. The broad measure of US inflation is trending upwards and is likely to rise further on a weaker US$ and significant oil price rises. Some analysts are predicting the US Consumer Price Index (CPI) to be 3% this year while the consensus is currently lower at 2.5%.
Inflation is however beginning to rise at the same time as ultra-accommodating monetary policy is coming to an end. Many analysts fear that the unwinding of the Federal Reserve’s Quantitative Easing (QE) programme and a rise in inflation could have a negative impact on both bond and equity markets.
Despite the evidence of growth in US inflation, other countries are at very different points in their economic cycle. Inflation in Europe and Japan continues to remain below target and wage growth is subdued. While the annual US CPI increased by 2.5% in April up from a 2.2% increase in February, this is not the story around the rest of the developed world. Eurozone inflation stood at 1.2% in April well below the ECB’s 2% target. Japan’s CPI is standing at 1.1% up from 0.5% in November 2017. China’s year on year CPI fell from 2.1% in March to 1.8% in April. In the UK, inflation has fallen from a high of 3.1%in November 2017 to 2.5% in April. The OECD has confirmed that inflation is falling in the majority of member countries.
Recent strong US wage and job growth spooked markets over the expectations of inflationary pressures. Core inflation, which excludes energy and unprocessed food prices, remains unchanged at 2.1% so recent wage rises seem not to have so far impacted inflation as much as some feared. The link between wage growth and inflation has been weak for some time. Therefore the heavy sell off over inflation looks as if it could have been an overreaction.
The American economy has been regularly adding an average of 200,000 new jobs per month. The number of non-farm payrolls increased by 103,000 in March and 164,000 in April when economists were expecting around 192,000 new jobs to be created. Despite this, the US unemployment rate fell below 4% to 3.9% for the first time since 2000.
Wage growth stood at 2.9% in January but fell to 2.6% in March and April. This reduction in wage growth may however start to rise as employment levels are now so high. The number of workers now voluntarily leaving their jobs for a better paid one is historically high reflecting confidence amongst employees. Wage growth has in the past been a lagging indicator of price inflation.
Jerome Powell, the newly appointed Chair of the US Federal Reserve has set out his plans for steady tightening of US interest rates. Mr Powell believes that the US is still yet to hit full employment and is waiting for a sharper acceleration in wage growth to signal that the labour market is getting too tight before he takes any additional action.
The central aim of QE was to aid money supply, improve liquidity, and push down interest rates and inflation. Now that QE is being reversed, investors are concerned how far and how fast interest rates may rise in future. If interest rates increase at the expected levels that the Fed has intimated then markets will take this in their stride. If inflation behaves so will interest rates and equity values. Markets can withstand higher rates, but investors will be sensitive to the pace of rate rise increases if the Fed does have to bear down on inflation. The risk of an accidental crisis or policy mistake remains.
Recent strong US wage and job growth spooked markets over the expectations of inflationary pressures.