US inflation is set to rise. The Fed must act now
- Stephen Roach says trade war’s impact on global value chains and the tight US labour market will fan inflationary pressures of the current US economic upturn
- The Fed is right to press on with monetary tightening – perhaps even at a pace faster than the market expects
It was inevitable. Another upturn in the US inflation cycle is at hand. Since the “Great Disinflation” of the early 1980s, when the annual increase in the consumer price index plunged from 14.7 per cent in March 1980 to 2.4 per cent in July 1983, inflation has generally remained in a relatively narrow 1-5 per cent range for a quarter of a century.
When the economy softened, inflation slid to the lower end of that range, and when it strengthened, it moved to the upper end. Such is the case today.
A confluence of global and domestic forces is starting to push inflation higher and should continue to do so for some time. That will pose a challenge to the Federal Reserve, which operates under a price-stability mandate. Recent volatility in stocks and bonds suggests that these risks could prove vexing to financial markets as well.
The global risk to US inflation reflects not only a cyclical upturn in the world economy, but also mounting trade frictions that pose serious threats to the stability of global value, or supply, chains.
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As global value chains have grown in importance over time, so has the internationalisation of inflation. In economic terms, that means broadening the assessment of inflation risks from a focus on domestic “output gaps” – the difference between actual and potential (or full employment) gross domestic product – to the global output gap.
Two major disruptions currently occurring in global value chains are likely to have a meaningful impact on the internationalisation of US inflation.
First and foremost is the Trump administration’s trade war with China. The initial waves of US tariffs on Chinese imports are aimed mainly at intermediate goods that are processed by low-cost China-centric global value chains. These tariffs will raise the prices of about half of Chinese goods imports by 10 per cent today and 25 per cent in 2019.
The recent reworking of the North American Free Trade Agreement should also have an impact. With its more stringent local-content and minimum-wage requirements, the United States-Mexico-Canada Agreement injects new cost pressures into the global value chain that has played an important role in the establishment of an integrated North American auto production platform over the past quarter of a century.
Meanwhile, the domestic pressures stem from a more familiar source: an extremely tight labour market. The unemployment rate fell to 3.7 per cent in September, its lowest level since December 1969.
The current tightness of the US labour market is problematic for two reasons. The first is a nascent increase in long-dormant wage pressures.
Moreover, there are signs that wage gains are now broadening out, with the balance tilting away from low-wage-inflation industries such as manufacturing, health care, and education into higher-wage-inflation industries such as finance, the information sector, and professional and business services.
At the current sub-4 per cent unemployment rate, overall wage inflation could easily move into the 3.5 per cent zone by mid-2019.
The second conclusion is that, unlike earlier periods of low unemployment when domestic wage pressures were constrained by global value chains, today’s mounting wage inflation will be tempered by a smaller global value chain offset.
Absent an unlikely acceleration in productivity, it is the confluence of these two forces – a tight domestic labour market and new global pressures – that spells trouble on the US inflation front.
Such an outcome has actionable consequences for the Fed. The federal funds rate is currently at only 2.25 per cent. That is little different from the underlying rate of so-called core inflation, currently running at 2-2.2 per cent.
Therein lies the Fed’s dilemma. Knowing full well that monetary policy works with lags of 12-18 months, the central bank has to be forward-looking, setting its policy rate on the basis of where it thinks inflation is heading. And, based on the global and domestic pressures outlined above, 3-3.5 per cent inflation is well in sight over the next year.
To counter such a likely upturn in US inflation, the Fed is entirely correct to send the message that there is considerably more to come in its tightening cycle. That could mean the Fed must contemplate monetary tightening that significantly exceeds the so-called comfort zone of normalisation which financial markets are currently discounting.
Unlike a certain Fed-bashing president, I would hardly call that a crazy conclusion.
Stephen S. Roach, a faculty member at Yale University and former chairman of Morgan Stanley Asia, is the author of Unbalanced: The Codependency of America and China. Copyright: Project Syndicate