The Threat of Inflation

From the Trading Diary:

I received a message from a US reader suggesting I should “stay out of politics”.

I would love to stay out of politics. Frankly, I find it tiresome. Unfortunately, politics and the economy are so intertwined as to make the study of one meaningless without consideration of the other. I say “unfortunately” because a lot of the damage done to the economy is caused by the political system.

As for Donald Trump, I am a conservative but do not support him. He is not another Reagan who can lead from the center and inspire his country. If anything he is a polarizing force, more ego-driven than Nixon and just as unpredictable.

I hope I am wrong. Trump has many sound policies and has made some solid appointments to his team. Don’t believe everything you read from a hostile media. They could do a lot of good. Provided they are able to manage the elephant in the lifeboat — the destabilizing side of Trump’s nature.

Now that I have offended at least half of all US readers — slightly less than half if you listen to bleating about the majority vote — let me explain why politics and economics are so intertwined.

Apart from trade wars, which I will discuss at a later date, I see the main threat to the US economy as inflation.

Before I start, let me say that these dangers are not immediate and the present boom is likely to continue for the next 12 to 18 months. But they could quickly materialize, bringing the boom to a premature end, so it is best to keep a weather eye on them.


Earlier this week I discussed why the inflation outlook is so important to stock market performance:

From Tim Wallace at The Sydney Morning Herald:

Nine years on from the start of the financial crisis, the US recovery may be overheating, Legal & General Investment Management economist James Carrick has warned.

He has predicted a series of interest rate hikes will tip the US into a 2018 recession.”Every recession in the US has been caused by a tightening of credit conditions,” he said, noting inflation is on the rise and the US Federal Reserve is discussing plans for higher interest rates.

Officials at the Fed have only raised interest rates cautiously, because inflation has not taken off, so they do not believe the Fed needs to take the heat out of the economy.

But economists fear the strong dollar and low global commodity prices have restricted inflation and disguised domestic price rises. Underneath this, they fear the economy is already overheating.

As a result, they expect inflation to pick up sharply this year, forcing more rapid interest rate hikes.

That could cause a recession next year, they say. In their models, the signals are that this could take place in mid-2018.

Harvard scholar Paul Schmelzing points out that inflation is starting to rear its head in both China and Germany, with producer prices rising. This may in part be a result of the falling value of the Yuan and Euro against the Dollar, resulting in higher domestic commodity prices.

The opposite, however, is true for the US, with a rising Dollar lowering import prices and acting as a headwind against inflation.

The consumer price index (CPI) is rising because of higher crude oil prices but core CPI (excluding food & energy) has remained fairly constant, around the 2.0 percent target, over the last five years.

Core CPI and CPI

So why the concern?

Well the Fed is more concerned about underlying inflation, best reflected by hourly wage rates, than the headline CPI figure.

A sharp rise in hourly earnings rates would force the Fed to respond with tighter monetary policy to take the heat out of the economy.

The chart below shows how the Fed slams on the brakes whenever average hourly earning rates grow above 3.0 percent. Each surge in hourly earnings is matched by a dip in the currency growth rate as the Fed tightens the supply of money to slow the economy and reduce inflationary pressure. And tighter monetary normally leads to recession.

Hourly Earnings Growth compared to Currency in Circulation

Two anomalies on the above chart warrant explanation. First, is the sharp upward spike in currency growth in 1999/2000 when the Fed reacted to the LTCM crisis with monetary stimulus despite high inflationary pressures. Second, is the sharp dip in 2010 when the Fed took its foot off the gas pedal too soon after the financial crisis of 2008/2009, mistaking it for a regular recession.

Hourly earnings growth is currently at 2.5 percent, so the Fed has some wiggle room and is only likely to react with tighter monetary policy when the figure reaches 3.0 percent.

Recent rate rises are more about normalizing interest rates — not taming inflation — and are not cause for alarm.

But Paul Schmelzing warns that the combination of a tight labor market and fiscal stimulus could fuel inflation and lead to a bear market in bonds similar to the 1960s.

That is exactly where Donald Trump is headed with a major infrastructure program likely to hit the ground next year. In a tightening labor market, the Fed would be forced to tighten monetary policy, slowing the economy and leading to another bear market in stocks as well as bonds.

Politics is tricky; it cuts both ways. Every time you make a choice, it has unintended consequences.

~ Stone Gossard

12 Replies to “The Threat of Inflation”

  1. What a strange thing to say to you, Colin. Did he/she really suggest you should “stay out of politics”? Goodness me; did he/she give a reason? I’m assuming you must have said something that he/she disagreed with and therefore wanted you to not say anything else like it? And this from the land of (I laughingly chortle) free speech.

    It rather smacks of the “don’t insult my Jesus/Abraham/Muhammad/Harry Potter” lot who can’t cope with rational disagreement and discussion. How telling of our times.

    I guess fake news is easier to spell than propaganda. Joseph Goebbels would be so proud of the Trumpeters, as would V for Vendetta’s Chancellor Sulter if he wasn’t fictional. Give it a few years and he won’t be.

    Stay out of politics! That’s the funniest thing I’ve heard all week. Or possibly the saddest.

    1. I don’t mind, but they left the message on our answering service and didn’t leave a name. Obviously annoyed that I had the temerity to question the Great Leader’s actions (or is it “Dear Leader”).

  2. I am surprised that you automatically assume that it is a Trump supporter. I would assume it is a person of the Left that is devoting a great deal of effort rioting to stop debate and discussion. If you don,t know what is going on, I suggest you go to Reason Foundation website ( a Libertarian org in the U.S.) and see the story entitled ” Trump Haters Rush to Buy the Famous Dystopian Novel”.
    Of course you could be correct. There is a lot of wackiness on both sides.

    1. Vic, The Message was left after I had commented on Trump so I assume it came from a Trump supporter. But you are right: there are loonies on both sides.

  3. I wouldn’t think anyone but casual readers would require an explanation of the impact of politics on the economy. Perhaps the reader thinks you should not take sides in politics? But then it’s your website and you can say what you want. I agree that Trump’s proposed infrastructure spending is likely to have unintended consequences (as will many of his policies), particularly with respect to wage and even price inflation. And if he really deports 3 to 11 million undocumented immigrants, what effect will that have on wages and prices? Or if he starts a trade war with Mexico or China?

  4. Could you please provide the link to the second FED chart showing the percentage increases in average hourly wages? The FED web site is just taking me in circles searching for it. Thank you! Great post!

  5. Colin, historically inflation has been associated with rapid ecomic growth and large government expenditures (think wars or their aftermath). The Q4,economy in the US grew at 1.9% with 1% being due to inventory growth. Not exactly the kind of growth normally associated with inflation. Although prospects are good for big infrastructure spending, it usually takes 3-5 years to actually get to significant expenditures. As an example, 3 years after Obama announced his “shovel ready projects”, 20% of the money had been committed. It seems the shovels hadn’t been manufactured in China until more than 3 years elapsed. I just don’t see the conditions for inflation in the timeframe I usually worry about. If anything, global supply of almost everything seems to exceed demand.

    1. Vic you are right, there will be a delay in implementation. Hopefully that will be enough to keep inflationary pressures under control. But keep an eye on wage rate growth in case it isn’t.

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