Adjusting Expectations11/30/-1 Author: Dr. Charles Lieberman, Chief Investment Officer
The growing scarcity of labor is now slowing the pace of hiring, but adding to upward pressure on labor costs, which will soon flow through into price inflation. For those wondering when the economy might reach full employment and start generating inflation, evidence is mounting that we have already passed that critical point. Ongoing job growth will only reinforce this growing trend, so stimulative policies would now be unnecessary and problematical. So, there are significant risks to the incoming Trump Administration’s likely fiscal policies.
Janet Yellen expressed a desire just a few months ago to run the economy hot by keeping interest rates down for as long as possible. This approach was feasible, as long as inflation remained below the Fed’s target. But she’s already backed away from that view, almost certainly in reaction to the plunge in the unemployment rate and the rise in wage inflation. She and her colleagues at the Fed understand the message evident in the data. A few Fed doves prefer to keep rate hikes to a minimum anyway, but their ranks are declining, as the data mounts to support the views of the hawks. The FOMC has already adjusted its projections for this year to show three rate increases from two, but even this remains data dependent. A fourth rate increase, as had been projected originally in 2016, should be considered a viable possibility. Yet the market isn’t even priced for a third hike in 2017. Investors still need to wrap their heads around this possibility.
The labor market remains the key driver behind the Fed’s policy decisions and it may also influence the policy options of the incoming Trump Administration. Political rhetoric notwithstanding, fiscal stimulus at this stage of the economic expansion will mostly just push up inflation, while doing little to promote more job growth. So if the new Administration’s policies are only expansion oriented and are not supplemented by deregulation that free up resources, increased inflation will force the Fed to hike rates faster and by more. Moreover, the Fed clearly understands this, as revealed by the latest minutes. In contrast, it is not clear the market gets it. Investors seem to think there are still plenty of unemployed workers left to hire, even as the behavior of wages contradicts this myth. Some investors think a strong dollar will retard exports and domestic growth, and a few rate hikes will be sufficient to contain growth and inflation pressures. But if domestic excess demand pressures are relieved by increased imports, the US will be driving global growth higher at the same time foreign macro policies remain expansion oriented. A stronger global economy will raise foreign interest rates and limit dollar appreciation. So, we see little relief to the domestically generated inflation pressures that are being brewed.
Investors are optimistic for the corporate sector for good reasons. The economy is growing, profits are rebounding and tax cuts will turbocharge after-tax profits further, increased infrastructure spending is deemed a high priority, and policy remains highly stimulative. On balance this all seems like good news. And in a different economic context, particularly if unemployment were higher, such policy initiatives would be welcome. Under prevailing economic conditions, planned policy changes will exacerbate inflation problems if these expansionary policies only promote even faster hiring. They must also relieve stress in the labor market by increasing productivity or reducing regulatory impediments to output. How this influences the new Administration’s economic advisors and policies is, of course, unknown at this stage. The next few months will clarify how this will play out.