Inflation and the Fed

• The US Federal Reserve kept policy unchanged at its first meeting of 2021, holding the Fed Funds rate at 0.25% at the upper bound and maintaining monthly purchases of Treasury and agency mortgage-backed securities at USD 120bn/month.
• The trajectory of the Covid-19 pandemic and rollout of vaccinations remains the main economic variable the Fed is tracking as far as determining the outlook for the US economy and noted that conditions had “moderated” recently.
• Fed Chair Jerome Powell said any talk of tapering of asset purchases was “premature” but of interest to us was his commentary that higher inflation in the months ahead would be “transient.” Crucially, Powell noted that “disinflationary forces are still in effect” and that “troubling inflation seems far away and unlikely.”
• We have no doubt that inflation will begin to pick up in the US this year on base effects alone after hitting an average of just 1.2% in 2020. However, we assign a low probability that inflation will accelerate significantly in the medium term, keeping Fed rates anchored at low levels.

Markets getting ahead of underlying trends

Market expectations of US inflation have been pushing higher as the economy came out of the Q2 2020 Covid-19 collapse. But they have accelerated even more since the presidential election in anticipation of a wave of fiscal stimulus that will allow the US economy to recover and push prices higher. Breakeven levels for 10yr inflation in the US have now moved above 2% although they have moderated a touch after hitting a peak of nearly 2.18% in mid-January.

Inflation expectations pick up on recovery and stimulus hopes

Source: Bloomberg, Emirates NBD Research

The move in inflation expectations and optimism around the recovery has helped to bring UST yields higher, at least on the longer end, with 10yr UST yields hitting a peak of 1.1855% in mid-January before moderating closer to the 1% handle at the end of the month. The move seemed largely predicated on electoral wins in Senate runoffs for the Democrats and the steady transition to the Biden administration.

We still remain cautious on how easy it will be for the Biden administration to introduce new stimulus programmes given the president’s inclination toward bipartisan policymaking. Nor do we think that spending is likely to be as large as USD 1.9trn that is being targeted. A large amount of spending is still likely to hit the economy at some point in 2021—probably later than the market may be expecting—but it will have to push against long-term disinflationary effects that are keeping inflation anchored near record low levels.

Slack prevalent in labour market

The US economy is firmly on a recovery track—the IMF revised up its real GDP growth expectations for 2021 to 5.1%, an upward revision of 2 percentage points—but it is carrying over a tremendous amount of slack. Headline unemployment has improved from its Q2 peak of nearly 15% but at 6.7% as of December 2020 remains at levels last seen in 2013. Continuing unemployment claims at 5.6m are still more than twice as high as their median level in the last five years and initial claims have crept back up to near 1m on a weekly basis in recent data prints.

Job growth appears to have limited upward pull on prices

Source: Bloomberg, Emirates NBD Research

Moreover, even during the strong employment gains during 2015-19 when the unemployment rate fell from 5.7% to 3.6% the PCE deflator peaked at 2.1% and barely managed to hold above 2% on a sustained basis. Powell himself has questioned the link between unemployment and inflation, saying in 2019 that the relationship “has become weaker and weaker and weaker” in testimony before a Senate banking panel.

Under the Fed’s new inflation targeting framework, the bank is pushing back against concern that letting the labour market run hot would contribute to inflationary pressures and Powell seemed to signal a willingness to keeping policy accommodative even after the economy fully reopens, saying in his press conference this week that the Fed would “keep in mind people whose lives have been disrupted” and would “look out for those people and help them find their way back into the labour force.”

On a long-run metric as well, slack is well entrenched in the US labour market. The participation rate has steadily fallen since a peak of around 67% of the working age population in the early 2000s to 63% before the Covid-19 slump and has only bounced to around 61% in recent labour market data prints after falling to 60.2% in April 2020. That would seem to imply that on a long run there is still considerable capacity in the US to absorb higher unemployment before it has a material upward push on wages and prices.

Industry carries over excess capacity

Industrial capacity in the US has also come out of each major US recession in the last 25 years with more slack. Capacity utilization naturally slumps during periods of recession—see highlighted sections in chart below—but then has plateaued at lower levels post recovery than prior to recessions. Broader globalization trends likely contributed to more excess industrial capacity in the US as production moved offshore and cheaper wages/higher productive helped to drive down inflation.

The Covid-19 pandemic highlighted the vulnerabilities in relying on global supply chains and a general trend toward de-globalizing the economy may be underway, although if it is indeed occurring it is likely to be in early stages. But re-shoring production will be a long-run process and the same slack that developed in the US economy has likely occurred in exporting economies too: capacity utilisation in the Eurozone is slightly better than in the US but still displays the same long-terming declining trend.

US comes out of past recessions with excess industrial capacity

Source: Bloomberg, Emirates NBD Research. Note: shaded areas represent US recessions.

We acknowledge that industry and manufacturing is in long-run decline as a share of the US economy, falling to 11% of nominal output in Q3 2020 compared with more than 13% in Q1 2005. But the excess industrial capacity in the US provides room to accommodate greater domestic output and demand without adding materially to price pressures in the short-term.

The digital sector of the US economy is also growing in influence—hitting nearly 9% of total GDP as of 2018 according to the latest BEA data and likely expanding during the pandemic period as more consumers turned to online shopping and consumption of services. Output prices in the digital economy have showed a long-run tendency toward declining—in line with more processing power for smaller devices. The advent of significant remote working optionality since the pandemic began, allowing workers to live in cheaper areas and have their pay adjusted accordingly, could also serve as a long-run drag on inflation.

Digitization a long-run drag on inflation

Source: Emirates NBD Research

Implication for rates: low.

The implications of a prolonged low inflation economy are that rates remain anchored at their low levels. Japan’s experience is perhaps the best case study for long periods of low inflation, abetted by consumers and firms paying down debt rather than consuming and investing. FOMC policymaker still see rates at their current level of 0-25% until the end of 2023 and updated economic forecasts will be released after the March meeting. The trigger for rates going higher is unlikely to come from inflation but rather broader measures of economic health, particularly in the labour market.

Our own expectations is that the Fed holds rates unchanged this year and have tentatively penciled in a 25bps hike for the end of 2023. That will help to keep funding and rates markets anchored around their current levels although we do expect to see some curve steepening in response to optimism about the US economy. However, we are less bearish on USTs than the market appears to be at the moment and expect yields on 10yr UST to record a more modest climb this year.

Source: Bloomberg, Emirates NBD Research.