Low inflation and even deflation is a feature of the long and slow recovery from financial crises.
Extrapolating very low inflation of the post global financial crisis era is making central banks cautious in removing monetary stimulus and investors complacent of upside inflation risks at this stage of the economic cycle.
Claims of ‘the death of the Phillips curve’ are premature, with wage inflation in Europe and Japan, as well as the US, accelerating as the unemployment rate falls to pre-financial crisis lows. Monetary policy across the major economies remains accommodative despite shrinking spare capacity and rising inflation pressures. Moreover, popular demand for higher minimum wages and the end of fiscal austerity, as well as trade protectionism, add inflationary fuel to the fire.
WAGE GROWTH ON AN UPWARD TREND
Source: US Bureau of Labour Statistics, Japanese Ministry or Labour, ECB, latest data as at November 2018
A data-dependent Fed
Shrinking output gaps and rising wages will encourage central banks to ‘normalise’ monetary policy. If the incoming data confirms that the US economy is operating above potential and unemployment is posting new historic lows, the Fed will continue to reduce the size of its balance sheet and raise rates. Interest rate futures currently imply that the Fed hiking cycle will end next year at around 2.75%, implying just one rate hike in 2019 in addition to a 0.25% increase at its last meeting in 2018.
In our view, the Fed is more likely to hike rates three times next year rather than once, in light of another year of above-trend economic growth and rising wage and price inflation pressures. It is likely that during 2019, the 2yr-10yr Treasury curve will be flat with the 10-year Treasury yield peaking around 3.5%.
- Low unemployment and rising wages
- Shrinking spare capacity
- Trade protectionism
- Accommodative financial conditions
DIVERGENCE BETWEEN FED PROJECTION & MARKET EXPECTATIONS
Source: Federal Reserve; Bloomberg; latest data at 29 November 2018
Europe and Japan playing catch up
ECB forward guidance precludes it from raising interest rates until after the summer of 2019. But if the eurozone continues to expand at a rate closer to 2% than 1%, domestic inflation pressures will build and could lead to a re-pricing of market expectations of the current very flat path of ECB tightening.
Consensus discounts any tightening by the BoJ despite unemployment at a 25-year low, rising wages and worries that negative rates and a flat yield curve pose financial stability risks.