Photographer: Andrew Harrer/Bloomberg
Economists at Odds With Traders on Global Inflation OutlookBy , , and
Yellen maintains ’best guess’ is for U.S. inflation to pickup
Markets signal less concern about inflation accelerating
Wall Street economists are clashing with Wall Street traders over whether inflation is poised to awaken around the world after a long slumber.
From Morgan Stanley to Bank of America Corp. there’s a growing chorus of economists siding with Federal Reserve Chair Janet Yellen’s “best guess” that price pressures will soon gain momentum, paving the way for the Fed and other key central banks to continue unwinding ultra-loose monetary policy in a gradual fashion.
The message is still to fully get through to financial markets. The U.S. Treasury bond yield curve has flattened and German bond yields fell even after the European Central Bank announced plans to slow stimulus. JPMorgan Chase & Co. economists say markets assume inflation-adjusted interest rates in developed economies will stay below zero until 2019.
Which side is right will prove a tone-setter for markets in 2018 after a decade in which the financial crisis and subsequent global recession neutered inflation and prompted speculation it would never ignite despite the best efforts of central bankers.
“There is this narrative that has developed in the market that inflation is going to stay low forever,” said Arend Kapteyn, investment bank chief economist at UBS Group AG in London. “The point we’re starting to make is first of all you have to be very careful with that.”
Kapteyn is not alone. Ethan Harris of Bank of America Corp. calls rebounding U.S. inflation “the call” of 2018, while Morgan Stanley’s Andrew Sheets tells clients that the "Fed will hike more than the market expects" next year.
“At some point, the market will begin to price in something like what the Fed has advertised,” said Michael Spencer, global head of economics at Deutsche Bank AG in Hong Kong. “There is a risk in that adjustment process that bond yields do suddenly spike up."
Traders anticipate a Fed rate increase in December and only see rates about one quarter-point notch higher next year, according to pricing in interest rate futures, while Fed projections signal three 2018 hikes following a move next month.
The risk of an inflation surprise extends beyond the U.S.
Global consumer prices will rise at a 3 percent annualized pace this quarter, roughly twice its average pace in the first half of the year, JPMorgan Chase analysts wrote in a Nov. 10 note. It’s already hit 3 percent in the U.K. UBS estimates that inflation outside of food and energy prices accelerated in almost three-quarters of the industrial economies it monitors, the most since 2011, and warns the markets’ view of Japan is the most mis-priced.
Investors have been unmoved, perhaps because inflation in recent months has been softer than expected, particularly in the U.S., though data released Wednesday by the Labor Department showed core U.S. consumer prices rose 1.8 percent in the 12 months through October, compared to a forecast gain of 1.7 percent.
The spread between yields on nominal and inflation linked Treasury debt, known as the breakeven inflation rate and viewed as investors’ outlook for price pressures, predicts U.S. consumer prices will average only about 1.94 percent over the next 30 years. And a bond market inflation gauge the Fed uses to help guide monetary policy is at 1.77 percent, down from 2.07 percent in January.
In another signal bond investors aren’t very worried by the risk inflation will erode their fixed-income payments, the yield curve continues to flatten. The spread between five- and 30-year yields fell on Tuesday to 76 basis points, marking its flattest since November 2007.
The flatter yield curve suggests “the market is saying maybe the Fed is about to make a policy mistake and hike rates too much in a world where there is no inflation.” said Jim Leaviss, head of retail fixed interest at Prudential Plc’s M&G Investments.
At the heart of the debate is whether economies work as they have traditionally done and that inflation materializes when demand heats up.
Central bankers reckon it is business as usual. “Fundamentally, we know how inflation works,” Bank of Canada Governor Stephen Poloz said on Nov. 7. “The laws of supply and demand have not been repealed.”
Yet there have been false dawns before with inflation repeatedly undershooting central bank targets despite rock-bottom rates and unprecedented bond buying. The Fed, for example, has been beneath its 2 percent goal for most of the last five years.
Multiple reasons are given for the miss including fallout from the crisis, globalization, technological advances, a breakdown in the link between employment and wages, weak commodity prices and the rise of online shopping.
The turn seen by economists now is mainly rooted in the fact that demand is picking up. Three-quarters of the world economy is expanding, in turn forcing down unemployment across developed markets to 5.5 percent in September by JPMorgan Chase’s reckoning. That’s close to the lowest in 37 years and should eventually translate into companies raising wages and in turn prices.
Other inflation forces are building. West Texas crude oil has climbed more than 30 percent from its June low to a level unseen in more than two years. China, the exporter to the world, is witnessing the strongest core inflation in six years, reflecting pent up price pressures.
Capacity constraints are the concern of Goldman Sachs Group Inc. economist Sven Jari Stehn, who reckons the long-term trend growth rate at which inflation picks up has fallen to 1.25 percent across major economies from 2.5 percent in the late 1990s.
As a result, the U.S., U.K., Canada, Sweden and New Zealand will all “hike interest rates over the next year to avoid overshooting their goals,” Stehn said in a report this month.
To be sure, few are predicting an inflationary surge, as many countries still have plenty of slack to absorb.
“We project a gradual climb in inflation from a low level that gives central banks the latitude to normalize slowly,” Bruce Kasman, chief economist at JPMorgan Chase, wrote in a Nov. 3 report. Still, if demand remains strong and unemployment keeps falling, “central banks will need to intervene sooner than markets currently anticipate,” he said.
— With assistance by Michelle Jamrisko