Is inflation coming out of hibernation? A significant breakout of higherinflation is not our base case inflation outlook over the secular (three-to five-year) horizon. However, as labor markets tighten and the globaleconomy feels the ripple effects of growing populism across much of thedeveloped world, higher inflation certainly looks like a bigger risk thanit has been over the past decade.
The idea behind the potentialrude awakeningshighlighted in our latest Secular Outlook is that investors couldbe misled by their rearview mirrors – and inflation is one of the macrofactors that could look substantially different on the road ahead. For thepast 10 years, large output gaps in every part of the world ensured anample supply of labor. This logically translated into lackluster wagegrowth and limited price pressures.
Now nearly a decade into the recovery, unemployment rates have not onlyreturned to pre-crisis levels, but in some instances are reaching recordlows. In the U.S., for example, you’d have to go back almost 20 years tofind an unemployment rate below 4% – and our baseline forecast for 3.5%unemployment by the end of this year would be close to the record low of3.4% in the late 1960s (which preceded one of the largest and longestinflation episodes of the post-war era). In the U.K., unemployment is backto a level last seen in the early 70s. And while southern Europe is stilllagging and has plenty of spare capacity, Germany’s unemployment rate is ata multidecade low.
What happened to the Phillips curve?
Yet despite the tight labor market, wages have remained stagnant. This hasraised questions about the robustness of the so-calledPhillips curve– a cornerstone of most central banks’ frameworks which postulates that asan economy gets close to full employment, wages and inflation shouldaccelerate. Confronted with a long period of subdued inflation, centralbankers are de-emphasizing the predictive power of the Phillips curve andhave remained extremely cautious in removing their extraordinary monetarypolicy accommodation.
But what if the Phillips curve is alive and well, and hidden slack is thereason for depressed wage growth? If this is the case, central bankerscould already be behind the curve and may be keeping rates too low for toolong. And even if this is not the case, a growing number of central bankersappear comfortable with letting inflation run above their targets in orderto re-anchor inflation expectations at a higher level. The Federal Reserveitself is forecasting inflation above 2% in 2019 (as measured by personalconsumption expenditure, or PCE, inflation), yet reaffirmed its view thatinterest rates should be normalized at a slow and gradual pace. The dovishbias of central banks is still solidly anchored.
Fiscal expansion and populism may stoke the fire
Add to tightening labor markets two potentially significant drivers ofeconomic change that we identified in our Secular Forum: fiscal profligacyand rising populism. More and more countries have elected populistgovernments that are introducing serious doses of fiscal expansion throughtax cuts and potentially increased spending – all at a time when one wouldexpect deficits to contract. In the U.S., for instance, the budget deficitis growing despite very low unemployment and limited spare capacity in theeconomy, leading one to logically wonder how real output will be able tomeet the increase in aggregate demand (see Figure 1). And higher demandcoupled with constrained supply is a textbook recipe for higher inflation.
The impact of populism doesn’t stop at higher public deficits. Both thepopulist left and the populist right appear unified in their hostilitytoward globalization and trade. U.S.-imposed tariffs have been limited sofar, and we believe even the proposed 10% tariff on $200 billion ofadditional Chinese goods would have a measured impact on inflation; by ourestimates, it would raise core inflation by just 0.1% to 0.15% over thenext 12 months. The proposed tariffs on cars imported from Europe and Japanpose a larger threat, in our view, potentially boosting inflation by asmuch as 0.5%.
What about the tariffs’ longer-term impact? Much would depend on whether the U.S. can repatriate production from low-wage countries – adubious prospect, in our view, given near-full employment and theadministration’s restrictions on immigration. To gauge the potential impactover the next five years, we ran simulations based on the Federal Reserve’s FRB/US macroeconomic models,using different trade elasticities addressing the ability of the U.S.economy to replace imports with domestic production. We found inflation tobe higher in all scenarios, with some persistence effect.
Last but not least, oil prices continue to climb asOPEC struggles to increase outputamid production outages around the world (from Libya to Canada andVenezuela) and thesanctions on Iran.
Old patterns may not hold in a less-benign inflation outcome
While most markets and economists still have a benign view of inflation, wesee a material possibility of higher inflation that could have profoundimplications, not just on real returns across assets, but also on marketvolatility and portfolio construction. Many investors have grown accustomedto the reliably negative correlation between stocks and bonds as they seekto diversify and dampen volatility from portfolios of risky assets.However, as we have pointed out before, thiscorrelation has generally only been reliablewhen inflation is low or falling (see Figure 2).
To be sure, we believe high quality bonds will most likely provide aneffective portfolio hedge against the downside potential in risk assets inthe case of a recession, andwe see a recession as likely over the secular horizon; however, as the stock market correction earlierthis year demonstrated, this approach might not work as well if inflationfears are driving the risk-off moves. The correction in early Februarybegan with a much higher-than-expected Consumer Price Index (CPI) print inJanuary, followed by above-consensus wage data in the first week ofFebruary. At the same time, Treasury yields surged. If high quality bondscould not hedge your portfolio, so the logic seemed to go, then the onlyoption was to sell your risky assets – a conclusion that resulted inincreased market volatility and drawdowns in risk assets.
Yet the market assigns a low probability to persistently high inflation, asseen in the term structure of market-based measures of inflationcompensation, such as breakeven inflation (BEI). When comparing yields onnominal Treasuries to those for Treasury Inflation-Protected Securities(TIPS), for example, five-year BEI is now higher, at 2.21%, than 30-yearBEI, at 2.12%. This implies an expectation that inflation pressure willrise in the near term, perhaps due to the impact of higher commodityprices, near-full economic capacity or tariffs, but that inflation riskwill be much lower in the longer term.
Investor takeaways: Preparing for an inflation awakening
Although our baseline inflation outlook does not envision a rapidacceleration over the secular horizon, we see greater inflation risk thanin recent years – and we believe many investors may be underestimating thepossibility of a longer-term inflation surprise. Such longer-term riskcould be very disruptive; as Figure 2 shows, it would imply a change incorrelation between major assets by depressing prices for bonds andequities at the same time. This could be another rude awakening forinvestors who may have assumed their portfolios were balanced.
While we believe investor portfolios in general properly account for growthrisks, we think investors should consider whether they are adequatelyprotected against rising inflation. Considering a standalone or combinedallocation to real assets – such as inflation-linked bonds, commodities,real estate investment trusts (REITs) or other inflation-fighting assets –is one way investors may seek to hedge their portfolios and potentiallyenhance returns in the event that an inflationary regime emerges.
For more of PIMCO’s views on the complex drivers of inflation, please visit our inflation page.