MUNIX COMMENTARY – WEEK OF 10 May
Acronyms matter
Each month there is a plethora of economic statistics which economists examine to fine tune their inflation models. Commodity prices, currency movements, tax changes, even the weather, are all included. All these, and more, help determine the cyclical moves in headline inflation.
Every so often, these inflation forecasts are blown out of the water. Such was the case when the US statisticians reported that headline inflation had jumped to 4.2% in the year to April, about 1% higher than the consensus had expected. Inflation has reached its highest level for 13 years. It was no surprise that financial markets reacted sharply, despite an unexpectedly weak employment report in the USA a few days earlier. Bond markets sold off, the US dollar rallied, US share prices continued their sharp decline. The old adage of ‘Sell in May and go away, come back on St Leger’s day (in September) was refreshed by many a journalist.
There was something in the inflation report for both the doves and the hawks. The former could point to a series of special factors affecting April’s data – a month when the ending of the lockdown caused many strange effects. The hawks could say yet again how worried they have been by the excessive stimulus shown by the Federal Reserve and the Administration.
Truth be told, the direction of inflation was not a great surprise. Base effects, let alone supply side bottlenecks, had suggested that inflation should rise into the autumn and then begin to fall away. To give just one example, Fitch, the credit rating agency, suggests that global headline inflation will move up from 2.5% to 4% by the autumn and then retreat back to 2.5% by next spring.
The complex debate about inflationary pressures will involve much discussion about whether consumers and businesses are responding to a pipeline of higher raw material prices, a return to pricing power in key industries, the short-term effects of the stimulus cheques and such like. However, the Federal Reserve, and indeed other central banks around the world, will focus much more on core inflation, usually excluding food and energy, or trimmed median measures of inflation, removing outliers. Here are a few economic acronyms will start to matter – ECI and ULC.
US policy makers benefit from a broader array of economic statistics than in many other countries, including some useful analysis about unit labour costs (ULC, that is compensation divided by output) and the employment costs index (ECI, not just wages but e.g. payroll taxes and healthcare costs). While there are medical and housing costs which affect core inflation, and should not be ignored, over time the underlying rate of inflation is primarily determined by the costs base – primarily labour – and the ups and downs of productivity, which together determine corporate profitability.
The figures for Q1 were released a few days ago. Productivity was strong (an annual rate of about 4%) as the US economy snapped back, especially in March, whilst companies reported they were cautious in hiring new staff. This offset ECI (wages growth and other employment costs) running at 2.7% a year, so unit labour costs only rose 1.6% in the year to Q1. This also helps explain the strong profits growth reported by most US firms in the spring. Looking forward, will wage pressures start to appear as the economy returns to full employment, but can firms ensure that productivity growth remains strong, perhaps taking advantage of new technology?
The Federal Reserve, and again other major central banks, continue to emphasise the extent of the overhang of spare labour, whether employees on furlough or people actively seeking a job. In broad terms, employment in the USA is about 8 million below pre crisis levels. Whether jobs grow by closer to 1 million or 2 million a month will matter significantly, not only to close such a gap but also as it would provide a worse or better environment for workers to seek higher wages as they return to economic activity.
Such analysis might seem US centric. However, most developed economies face similar issues in coming months, including the UK. The faster the return to normality, the more likely that not only is there a surge in headline inflation but underlying pressures in the labour market begin to warn central bankers that they should start to take action. To end with a quote from Bank of England Chief Economist Andy Haldane “Now is the time to start tightening the tap to avoid the risk of a future inflationary flood”.
Andrew Milligan is an independent economist and investment consultant. This note should be considered as general commentary on economic and financial matters and should not be considered as financial advice in any form.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making