Deflation Banished, Inflation Vanished: The Economy Plods Along

09.25.2017 - Ronald J. Sanchez, CFA


  • International Markets Lift the Global Economy. Europe and Japan continue to outpace the US—a trend we expect to continue.
  • Technology, Globalization and Demographic Shifts Contribute to Lower Inflation
  • The Fed Approaches Rates Cautiously. Modest GDP growth and stagnant prices could mean a “slower and lower” rate path.

What a difference a year makes. As we enter the final quarter of 2017, one of the most striking observations in our outlook is just how dramatically the global economy and financial markets can change in a relatively short period of time.

Deflationary Fears Dissipate

Just one year ago, investors were facing an environment in which the US economy was plodding along, Europe’s economy was dragging and global interest rates were anchored near historic lows—including $14 trillion in negative-yielding sovereign bonds overseas. Deflationary fears were palpable.

Fast forward to today, and while we face that same frustrating US economy, growth in Europe has now converged, relieving pressure on the US economy to drive the global recovery. The stronger growth outlook has pulled interest rates higher, particularly in Europe where the amount of negative-yielding sovereign debt has fallen dramatically. But despite this recent stretch of broadening global economic expansion, inflation has decelerated (CHART 1).

In the US, inflation has stalled at roughly 1.7%, well below the Fed’s 2% target, while aggregate global inflation fell to its lowest level in nearly 50 years (CHART 2). This is a textbook example of a Goldilocks economy for investors—not too hot and not too cold.

Ideal Conditions for Investors

This unusual backdrop of weaker inflation and a stronger global economy was conducive for stocks, bonds and a wide variety of other asset classes with different risk characteristics throughout much of the year. Conditions were encouraging enough to lift global equities, which typically happens when investors are confident about the direction of the economy. These conditions also fueled persistent demand for income-producing assets.

With inflation in check and the economy growing, the Fed reassured investors that it will remain patient in its data-dependent approach to normalization. Despite two previous interest rate hikes by the Fed this year, there has been no pressure on long-term Treasury bonds, with yields actually falling year to date. Investors’ willingness to own 30-year debt at these levels reflects a degree of comfort that the future inflation environment will look a lot like the present one (CHART 3).

A benign rate environment and strong financial conditions have also calmed the markets. A weaker dollar, subdued energy prices and ample credit paved the way toward a slow, steady grind higher in equities, which in a “virtuous circle” further supported financial conditions. In mid August, risk premiums were near post-crisis lows. And despite a few geopolitical shocks, including a volley of threats between the US and North Korea, the S&P never fell more than 1.8%. By comparison, during the same period last year, we had seven moves of that magnitude.

The New Normal

The durability of this benign economic environment has largely beguiled global policymakers. While they are eager to unwind the extraordinarily accommodative monetary policies introduced over the course of the past nine years, the failure of their inflation forecasts to come to fruition has frustrated progress. Despite many within the Fed characterizing the labor market as “nearing full employment,” job gains remain robust. However, this has not translated into a meaningful uptick in wages. This fractured relationship between employment and wages, which are treated as correlated in many of the Fed’s models, has challenged monetary policymakers.

As we move forward, we would need to see a shift in labor market strength from headline payroll gains and a shrinking unemployment rate toward a persistent uptick in wage gains before viewing the Fed as pressured to move by the unemployment portion of its dual mandate. Progress on their inflation goal is likely to remain murky.

What Has Changed with Inflation?

Many theories—everything from cell phone plans to slowing housing price gains—have been offered to explain persistently weak inflation numbers post-financial crisis. Factors include globalization, technology, aging demographics, and a central bank “liquidity trap”—the Fed’s inability to push the US economy into second gear despite near-zero interest rates.

Globalization has clearly weighed on goods prices for over a generation as thin-margined companies competing on price have squeezed all input costs to maintain profitability. For much of the past five years goods prices have actually been negative, weighing on headline inflation. Services, particularly housing, have been tasked with doing much of the heavy lifting.

Others attribute the disconnect to technology, which is inherently anti-inflationary and which has effects that are difficult to isolate for in economic data. “Sharing” economy companies like Uber and Airbnb are disrupting the transportation and hospitality industries, while the relentless growth of Amazon has chilled brick-and-mortar retail.

One thing seems perfectly clear to us: technology is reshaping the world in ways that politicians, policymakers, educators and economists are just beginning to grasp. It touches every corner of our lives.

The rapid aging of the baby boomers also may play into this dynamic. Anecdotally, the largest generation reached their prime working years in the most inflationary decade. Now as they exit the labor market we may be seeing a reversal of that demographic effect. Interestingly, surveys show lower inflation expectations for younger respondents whose experiences didn’t include the turbulent 1970s.1 Also, Fed researchers have published studies showing how long-tenured and relatively highly paid employees retiring and being replaced by younger, cheaper workers could be restraining wage inflation.

Lastly, it now seems clear that central banks are not able to generate inflation alone. Their monumental efforts in stabilizing the economy were enough to provide a backstop during the worst of the crisis and a steady support during the nascent recovery, but the broadest benefits of accommodative policy have clearly been realized. The Fed seems better equipped to fight the last war on inflation than to push it higher in an era of slowing potential growth.

What’s Next?

In our view, rates have room to move without shocking the markets and are likely to remain accommodative by historical standards, especially as central banks “tightening” veers toward a slower pace and a lower terminal rate.

A risk in this scenario is that moderating inflation could signal that global economic growth, while not stalling, may not accelerate as fast as forecasters anticipated earlier in the year. In the absence of a strong catalyst for growth—such as comprehensive tax reform—we think the rate of US economic expansion is likely to remain near current levels in the near term, as weaker inflation and slower wage growth limit the pricing power of manufacturers and retailers in the US and abroad.

In general, we remain constructive on the global economy and financial markets but are mindful of the challenges ahead—softening of US economic data, dysfunction in Washington DC and the potential for monetary policy decisions at home or abroad that catch investors by surprise. While top-line valuations look more attractive in Europe and Japan, the US market appears fully valued, leading us to believe that the return profile will moderate. In other words, the “comfort margin” is thinner than we generally like to see in US equities.

1. Federal Reserve Board of New York.

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