Down Under Daily, 9 June 2014

The Cyclical Inflation Pick-up

I think developed economies are in a disinflationary
trend. However, in every cycle economic recovery
can temporarily overcome the trend and inflation,
wages and interest rates rise. A mild version of this
cycle upswing now seems in prospect in the US.
This should, in my view, push short-end rates
higher, consistent with the Feds rate forecasts.
Squint at Exhibit 1 and youll see that US core
inflation rates rising at the margin. Inflation rises at
some stage in every economic expansion; but as
Exhibit 1 shows, through the past 30 years inflation
has been cycling around a declining trend.
Exhibit 1
Its Unanimous: Inflation Rises At The Margin
6
THREE MEASURES OF CORE INFLATION
MEDIAN CPI
5
CORE CPI
4 CORE PCE
12M %
Arguably the most important inflation indicator for
policy in this cycle will be the price of labour
(wages) not the price of consumer goods and
services (CPI). Wage behaviour will settle a key
issue: how much slack is in the US labour market?
As is well known, there has been almost no
improvement through this US recovery in
employment relative to working-age population
(Exhibit 3). This implies that almost all the decline
in the unemployment rate, to 6.3% from a peak of
10.0%, is due to falling labour-force participation.
So the question on how much labour slack largely
depends on how much of the decline in the
participation rate is structural versus cyclical.
Exhibit 3
How Much Higher Can This Get?
THE EMPLOYMENT RATE*
65
64

63
3
62
61
2
%

60

1 59
58
0 57
1984 1988 1992 1996 2000 2004 2008 2012 2016 56

Source: BLS, Cleveland FRB, NBER; Minack Advisors 55

Inflation did rise through 2010-11, but that
reflected two oddities of this cycle. First, aggressive
Chinese stimulus drove a rebound in global
commodity prices, lifting headline inflation rates
around the world. Secondly, the swing to renting
lifted the price of shelter, a large component of core
CPI in the US. The new news is the hint that core
* PERCENTAGE OF WORKING-AGE POPULATION EMPLOYED (HOUSEHOLD BASIS)
54
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Source: BLS, NBER; Minack Advisors
It is mostly structural, in my view. Exhibit 4
suggests that most of the fall in the participation
rate is due to changing demographic mix.
Exhibit 4

inflation ex-shelter has inflected (Exhibit 2). Boomers Over The Hump
US LABOUR PARTICIPATION RATE
68
Exhibit 2 67

Core-core-core Inflects 66
PARTICIPATION RATE %

65
CONTRIBUTION TO US CPI INFLATION
6 64
DECEMBER 2012 WEIGHTS
5 63
HEADLINE CPI 62 PARTICIPATION RATE ASSUMING NO
4
CHANGE IN AGE/GENDER PARTICIPATION
61 FROM 2004-05 AVERAGE
3
12M %

60
2
59
1 WORKFORCE AS A PERCENT OF WORKING AGE POPULATION
58
0 1950 1960 1970 1980 1990 2000 2010

-1 CORE EX-SHELTER Note: Blue line holds fixed participation rates at the 2004-05 average for
-2 SHELTER the labour force split 10-ways: males and females split into five age groups
FOOD & ENERGY (under-24, 25-34, 35-44, 45-54 and over 55). The blue line moves only
-3
because the share in the labour force of these groups is changing.
2000 2002 2004 2006 2008 2010 2012 2014 2016
Source: BLS, NBER; Minack Advisors
Source: BLS, NBER; Minack Advisors

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Monday, 9 June 2014
Much academic ink is now being spilt on this. The for the Fed funds target. Although the consensus
key point for investors is that the issue will be macro view amongst investors seems consistent
settled by wages. If wages start to rise then it will with the Feds forecasts, rate markets are pricing a
be strong circumstantial evidence that the labour more dovish outlook for short rates. My view is that
force changes are structural. That, in turn, would be rising wages growth would force short-rate markets
a strong signal to a dual-mandated Fed that more towards the Feds own profile for rates.
weight needs to be put on inflation control.
Exhibit 7
There is already tentative evidence of wages A Dotty Forecast
responding. Real wages have picked up as 4.0
FED FUNDS TARGET, MARKET AND FOMC FORECASTS
LONG-RUN FOMC MEDIAN

unemployment has fallen towards the so-called 3.5 EURO-DOLLAR

FUTURES
natural rate (Exhibit 5). 3.0

2.5

%
Exhibit 5 2.0 FED FUND
TARGET
Excess Unemployed And Wages Growth 1.5
FED FUND
RATE
MEDIAN FOMC
3M LIBOR MEMBER
US EXCESS JOBLESS RATE AND REAL HOURLY EARNINGS 1.0 FORECASTS
2 -3.0
0.5 FED FUND
FUTURES
1 -1.5
0.0
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
% PT GAP [INV]

0 0.0
Source: Bloomberg; Federal Reserve; Minack Advisors
12M%

-1 1.5

-2 3.0
Rising wages, rising inflation, a more hawkish
REAL HOURLY EARNINGS* (LHS) pricing for Fed policy none of this sounds good for
-3 EXCESS JOBLESS** [INVERTED] 4.5
* EARNINGS LESS 3YR AVERAGE CPI ** UNEMPLOYMENT
bond yields. I do think long-end rates may back up
RATE LESS CBO ESTIMATE OF NAIRU [INVERTED]
-4
1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 2014
6.0
a little (warning: I thought that at the start of this,
Source: BLS, CBO, NBER; Minack Advisors so Ive been wrong). However, the bulk of the
adjustment will likely fall on the short-end of the
Likewise, companies are signalling that they are curve. Exhibit 8 shows that when the Fed funds rate
planning to increase compensation, which typically is low the front of the curve (spread between 2 year
leads wages growth (Exhibit 6). and Fed funds rate) is typically steep. Forward
guidance has kept that spread flat in this cycle. Now
Exhibit 6
this spread is flatter than implied by the Feds own
Time To Pay Up
guidance. This spread moving towards normal
HOURLY EARNINGS AND NFIB PAY EXPECTATIONS
5.0 25 not that I think it will go all the way points to
4.5
4.0
20 short rates rising faster than long rates. That is, the
3.5
15
prospect of a bear-flattening in the yield curve.
NET BALANCE

3.0
12M%

2.5 10 Exhibit 8
2.0
5
Whats Not Normal: Too Flat A Front End
1.5
REAL FED FUNDS RATE & 2 YEAR-FED FUND SPREAD
1.0 HOURLY EARNINGS* NFIB PAY** (RHS) 3 -2
0 2 YEAR-FED FUND TARGET
0.5 * PRIVATE NON-FARM HOURLY EARNINGS ** % PLANNING TO SPREAD (LHS) -1
INCREASE COMPENSATION LEAD BY 9M. 3M AVERAGE 2
0.0 -5 0
1986 1990 1994 1998 2002 2006 2010 2014
1
1
% [INVERTED]

Source: BLS, NFIB, NBER; Minack Advisors 2

%

0 3
The forward-looking point is that if inflation and 4
-1
wages continue to accelerate through this year it REAL FED FUND RATE
5
6
would increase the prospect of the FOMC delivering -2 TARGET* [INVERTED]
7

on its own interest rate forecasts. Exhibit 7 shows -3

* FED FUND RATE DEFLATED BY TRAILING 3 YEAR CORE PCE
8
1980 1984 1988 1992 1996 2000 2004 2008 2012
the FOMCs now-famous dots: the median forecast Source: Bloomberg, BLS, NBER; Minack Advisors

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Monday, 9 June 2014
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Monday, 9 June 2014