Inflation Puzzle: Back In Time

"Inflation typically rises during an economic expansion, peaks slightly after the onset of recession, and then continues to decline through the first year or two of recovery. During the present U.S. expansion, however, inflation has taken a markedly different path. Although more than six years have passed since ____, inflation in the core CPI (the consumer price index excluding its volatile food and energy components) has yet to accelerate."

Guess the missing time line in the above paragraph. It is from a paper from NY Fed, dated 1997. It refers to the 1990-91 recession. But it could easily apply to the 2008 GFC. With the benefit of hindsight, it is now questionable if the Fed should have been more hawkish during the 90s and 2000s to avoid the great financial meltdown. But in 1997, with all fairness, there was little support for more hawkishness in data.

A recent Bloomberg article talks about six million reasons for Yellen to think before raising rates. But I wonder if we will ever have those kind of jobs back in listing which the 60 somethings like Mr Elanko are skilled for. 20 somethings are working overtime and designing apps against Miss Yellen.

In a case of structural unemployment, the numbers matter less than the rate of increase in wage and employment cost. The Fed knows it. So for me, a December pause is more worrying than a hike.

Inflation: Think Global (In Chart)

A few observation on inflation from a global perspective

#1: Global inflation has been weak, but core has been steady. Here the global data points (like headline or core inflation) are calculated using the GDP weighted national measures of the top 20 countries in terms of GDP in current dollars (representing 79.9% of world GDP. Pareto!!).

The difference between the core measure and the headline is even more important as the wedge between them is currently driven mostly by a single factor - energy prices. The concept of inflation is an overall price rise. A change in a particular component is mostly a relative price change, not an overall price change. Central banks have little controls over production of individual goods and services. If there is a large relative price rise for doughnuts for some reason, a hike in policy rates most probably is not going to help it (unless this relative price rise permeates through the economy and finally in wage expectation through second round effect).

#2: The smack-down of inflation in commodity exporting countries is most prominent for the ones with fixed exchange rate regimes. With a few exceptions, most of the metal and energy exporters are not suffering any great dis-inflationary pressure in core measures otherwise.

#3: In terms of professional forecasts, inflation expectation remains steady, but the market based measures for the US are not so. 

#4: The consumer demand is weak. Especially if we measure in dollar terms. We have a scenario of low rates, a strong dollar, very weak commodity prices and weak global demand. Commodity prices respond a lot to investments expenditure globally. However, the consumption expenditure has been a relatively stable component of economies across countries and time historically. Since mid of last year the consumption expenditure globally in dollar term has been in a strong contraction phase, approx 6% from peak till Q2 2015. This is only matched by an approx 8% drop during the GFC. And this is not driven by US or China much, rather rest of the world, including Euro area and Japan. It is hard to say if this has bottomed out and we will see the savings from drop in energy prices being channelized to recover consumer demand. 

Nonetheless, the possibility of a wage driven inflationary pressure cannot be dismissed. The chart on the left shows scatter plot of job opening rate (JOLT), Employment Cost Index and PCE core inflation against headline unemployment rate on x-axis, since 1980. The starting points are marked in red and end points in green. As we see in case of job opening, there has been some significant hysterisis (unemployment rate higher, given the job opening, if we measure the slope from the earlier part of the curve). This may points to a case of structural problem in unemployment. That will put forth a case against a downward revision of Fed's unemployment target (NAIRU). On the other hand the wage inflation (here ECI) and broader inflation (PCE) still shows inverse relationship. The Phillips curve is still alive (esp. for wage inflation), although flatter in recent times. Given the fact that Fed action has always a lag before it affects the real economy, this will keep the case for a early hike on the table.

#5: And related to above point of global consumption, the global imbalance in excess savings seem to be heading towards a forced reduction. The left chart shows excess savings (or equivalently current account balance) in nominal dollar terms. As we can see the large CA deficit of US has historically been balanced by large surplus of Japan and lately China. The EM had a spike just after the late 90s Asian Crisis. But that is mostly negated now. The recent cause of concern (Euro Glut) was a large and ballooning surplus of Euro Area. With the fall in oil prices, the Petrodollar balance is now going the other way to counter it. These low commodity prices may play a crucial role in re-balancing the flow of trades and capital across the globe. ( it is evident from the chart that trade volume has come down significantly.) It is not clear to what extent this balancing act will help consumption and through what channel, but it is definitely better than exploding imbalances in the medium to long term.

Also since the financial crisis, after the very initial period, it has been mostly a battle fought by central bankers, with fiscal stimulus sitting mostly on the sideline. In fact the withdrawal of high fiscal stimulus just after the collapse might as well have countered central bank efforts. We are politically getting in a better position to consider and use fiscal stimulus than the height of European Crisis and talks of austerity. The global budget balance is in fact back to the pre-crisis average level. And if the economy is not, there is a good reason and scope for fiscal stimulus in coming years.

The key takeaways: Despite the weak global demands and large savings imbalance (which are related), there is a case that the commodity prices has done some corrections, and a persistent weak demand/ high global excess savings may not be realized. And we still have the upside of fiscal stimulus in case consumer demand needed a booster does. At a global level, most measures of core inflation, and non-market based inflation expectation remains robust. However, the market seems to be pricing a very pessimistic outlook for inflation globally. And also as mentioned earlier the inflation skew pricings are improving on the upside surprise.

Is this a case of peak (dis-)inflation worries and significant consolidation and upside from here. Hard to be sure, but I would say chances are good than they were before. Of course inflation can go either way from here, but in most scenarios they have a better chance of ending up higher than current levels. And a reasonable dollar weakness from here can tilt the balance in its favor further.

Trades

1) In case Fed is on time (which we will only know with the benefit of hind sight): long inflation upside and nominal rates sell-off with short dollar for cheapening.

2) In case Fed is delayed: long vol - a sharper rate of hike will catch many unsuspecting asset classes on the wrong foot.

Upside Surprise: What The Inflation Skew Prices In

Inflation is low, has been so, and is forecast that way for a while. I mostly agree. Nevertheless, let's look at the other possibilities. Below is a picture that captures what is driving the headline inflation in the US. Yes, no surprise here, it is the oil price.

If we take out that part though, things looks interesting. As we can see, a large contribution comes from housing. Most will perhaps agree the oil related part is transitory. So the real question is what about the housing. At this point it seems within the dual mandate of the Fed, the unemployment part as just a target number becomes less relevant. It is at 5.1%, can go down to 5.0% or go up to 5.2%, or there can be serious debate about what is the level of NAIRU. But the fact of the matter is over the past few decades the revered Phillips curve has weakened a lot. With a drop in productivity, and labor share of GDP, the unemployment number is a lot less related to inflation now. So for policy makers the real points are two-folds - look out for signs of wage inflation, and also look out for heating up of the housing markets (or risk premia compression in general). And so far we do not have any strong confirmed signs of any. Unfortunately the action of the Fed has a certain lag on the policy targets. So to move in after seeing confirmed signs of these may be too late. Which means a slow and steady path of hikes replaced by a delayed and steep one.

The market seems to seriously be thinking over it. These is based on the volatility markets of the US inflation. Which trades typically as zero coupon swaps on the CPI (urban) index and options on that. The chart below shows the implied vol of a 5y options at a 2% strike (blue), the vol premium (green, implied vol over the actual realized vol of the index) and the skew (red, difference in vols between a 2% and a -1% strike on right hand axis, note: these vols are approximate and implied from Bloomberg quoted price)

The inflation vols has picked up a bit recently (but nowhere near the paranoid inflation phobia in 2009 - 2010 following the QE), but the vol premium has shrunk has well. The strong negative skew since 2013 correctly predicted/ coincided with increasingly softening inflation expectation, and maintained the negative skew till very recently. (Apart from a short flare up of headline inflation in Q2 2014, which the Fed rightly called the bluff). But this is now almost reversed and poised for a come back on the other side. It seems although market is not much upbeat about the breakeven inflation forwards, it is increasingly suspicious of a further downside surprise. Contrast this with the vol markets nominal rates (USD swaptions), where the skew is now flipped on the receiver side for a while.