18 January 2022

In December, the US Federal Reserve abandoned its belief that rising inflation was “transitory”, and signaled that monetary tightening may commence earlier that expected. In their defense, the extreme imbalances in aggregate supply and demand in both labour and goods markets (e.g. supply chain disruptions) during the 2020/21 economic recovery have complicated the assessment of the inflation outlook. For example, while the 7% rise in December 2021 consumer prices was the highest in nearly 40 years, inflation is likely to peak in the next few months. Indeed, the US central bank’s favourite gauge of underlying price pressures (“core” PCE), is likely to decline below 3% by the end of 2022 (aided by base effects). Likewise, I expect US GDP growth to decelerate from 2021’s torrid 5.5% pace to 3.75% in 2022 (on a Q4 over Q4 basis), largely reflecting a sharp slowdown in consumer spending (note the 1.9% decline in December retail sales).

Many are encouraged by the prospect of slower growth and moderating inflation. However, I detect more troubling late-cycle characteristics. Despite slowing GDP growth, the US economy will continue to expand faster than its long-term potential this year (and perhaps in 2023 as well). As a result, the American labour market will reach full employment by the end of 2022: the unemployment rate will decline below 3.5% (compared to 3.9% at present). Wage growth will accelerate beyond 4% during the next 24 months. Consequently, “core” inflation will not only remain above the Fed’s 2% target this year, but in 2023 as well.

For the US central bank to achieve its dual mandate — full employment and 2% inflation — monetary policy may need to be tightened more than expected. Specifically, I anticipate the Fed will raise interest rate 25bp in each quarter of 2022 (previously I had anticipated only 2 hikes this year). These adjustments will commence at the Fed’s March meeting in order to start the process before headline inflation begins to decline.

Rising wages and the quickened pace of monetary tightening will have implications for profit margins, US bond yields (both nominal and real), and equity valuations. So far, financial markets have accepted the Fed’s reappraisal of the inflation outlook. Indeed, the Dow Jones equity index has risen since the 15 December Fed meeting (albiet the Nasdaq has declined). At some stage, financial market volatility (perhaps triggered by signs of economic deceleration) may test the Fed’s resolve to pursue its inflation target.

Supply Chains: Pipeline Price Pressures Remain Significant

As the global economy emerged from lockdown, global supply chain shortages contributed significantly to the rise in inflation, as production could not keep pace with booming pent-up demand. The Chart above, however, illustrates the impact of this disruption varies widely. Indeed, the United States — along with Europe — has been considerably more adversely impacted than the Asian economies.

Furthermore, these price strains do not appear to have eased yet. US producer prices and imported costs are still rising steadily (Chart above). These “pipeline” price pressures will eventually lead to higher consumer price inflation or adversely impact corporate profit margins.

U.S. Labour Market: Heading for a Wage-Price Spiral?

Ultimately, persistently higher inflation results from tight labour markets and accelerating wage growth. To be sure, the Fed’s shift on inflation reflects a significant tightening in the US employment market last year. Indeed, the unemployment rate is now only 3.9%. Perhaps more revealing, however, is the 2.8 percentage point decline in the jobless rate in 2021 — the largest annual fall in over 60 years!

But, does any slack remain in the US labour market? Despite the recent decline, for instance, the unemployment rate remains above the pre-pandemic level (3.5%). And, the number of employed people is still 3 million below December 2019. Some suggest that actual unemployment is higher than recorded, as over 2 million discouraged workers have left the labour force (perhaps temporarily) during the past recession, and will eventually seek jobs as the economy recovers. These trends suggest slack remains in the jobs market, and the recent uptick in wages growth simply reflects a temporary mismatch between labour supply and demand, especially in sectors such as hospitality and transportation.

I am a bit less saguine. The Chart above compares the number of unemployed people (labour supply) to the number of job openings (labour demand). By this measure, workers are not only more scarce than before the pandemic, but the labour market is at its tightest in two decades. To be sure, various factors have limited labour supply (and lowered the labour participation rate) during the pandemic: e.g. generous unemployment insurance, lower immigration, early retirement, and workplace health/safely concerns.

However, those hoping that an early recovery in labour force participation will boost labour availability and ease wage pressures may be disappointed. The Chart above indicates the participation rate among younger workers (less than 55 years old) has aready largely recovered. On the other hand, the rate for older workers remains depressed, suggesting these people may have opted for early retirement (as housing and equity wealth have soared).

Putting the pieces together, I suspect that on current trends the US labour market will approach full employment by the end of 2022. So far, the uptick in the employment cost index (the broadest measure of wages) has been fairly modest (Chart below). However, more timely metrics, e.g. average hourly earnings, indicate that that pressures are building. I expect wages to rise 4-4.5% in 2022 (fortunately, the largest gains will be for low-paid workers). Therefore, higher interest rates will be required to prevent inflation from becoming more entrenched.

Rest of the World: Less Labour Market and Inflation Pressure

Labour market conditions are less tight in many other parts of the world. Remarkably, European unemployment rates have declined sharply (and are now below pre-pandemic levels), despite the ending of generous worker retention programs. Nevertheless, the 7.2% jobless rate remains elevated; resulting in more modest wage pressures than in the USA (next Chart). The ECB, therefore, is unlikely to rush into tightening monetary policy this year.

Pressures are even more modest in Japan, as the 2.8% unemployment rate remains above pre-Covid levels. As a result, Japanese wages rose only 0.5% in 2021. The Bank of Japan will remain on hold.

The United Kingdom lies somewhere between the USA and Europe/Japan. Despite the ending of its successful job retention scheme, UK unemployment declined sharply last year, But, joblessness (now at 4.2%) remains above pre-pandemic levels, and above that in the USA. Wage gains are similar to the USA. Following its recent 15bp rate hike, the Bank of England will tighen monetary conditions another 50bp in 2022: more than the Eurozone, but less than in the USA.

Implications for Risky Assets

• The Chart above illustrates the rise in US bond yields during the past year has been driven by rising inflation expectations. On the other hand, real interest rates declined sharply, as US monetary policy remained highly stimulative. This breakdown will change in 2022/23. I project 10-year US bond yields will approach 2.5% by next year (up from my 2.1% earlier forecast). I agree with the market’s projection of roughly 2.5% for long-term inflationary expectations (breakeven inflation). However, the future rise in American yields will be driven by rising real interest rates (TIPS), as the Fed reduces liquidity, US budget deficits remain large, and business investment is robust. Specifically, real yields could rise 75bp towards 0% during the coming year.
• In my earlier blog (found in the archives) “Strategy 2022: Avoiding Stagflation”, I indicated that rising real (and nominal) bond yields could pose risks for financial assets. In particular, I projected that as US inflation-adjusted yields increase, the S&P 500’s P/E ratio would derate towards 18.5X 2022 earnings per share. Consequently, even though 2022 EPS growth may exceed expectations, the market index could correct towards 4,350 at some point this year. I stick with this view.
• As European inflation risks are more modest, the region’s equity markets will outperform in 2022/23. Ditto Japan.
• Rising US real yields will support the US dollar during H1 2022.
• Higher US yields and a strong dollar will remain headwinds for Emerging Markets for now. In Asia, more modest inflation risks will keep central banks on hold; indeed, China is still easing monetary conditions. Regional FX could weaken versus the USD.
• Crypto-assets could become more volatile, if real rates rise and the S&P stalls. In an earlier blog “Bitcoin: What it Is, What It’s Not” I indicated that BTC was highly correlated to American real bond yields and especially US stock prices (correlation coefficients of -0.6 and 0.8 respectively). Indeed, the correlation with US inflation is only 0.3%. Bitcoin, therefore, appears to a high beta, speculative asset rather than an inflation hedge at this stage. BTC could face substantial headwinds in the current environment. I continue to prefer ETH, which enjoys wider applications in the world of digital finance.