Is inflation coming out of hibernation? A significant breakout of higher
inflation is not our base case inflation outlook over the secular (three-
to five-year) horizon. However, as labor markets tighten and the global
economy feels the ripple effects of growing populism across much of the
developed world, higher inflation certainly looks like a bigger risk than
it has been over the past decade.
The idea behind the potential
highlighted in our latest Secular Outlook is that investors could
be misled by their rearview mirrors – and inflation is one of the macro
factors that could look substantially different on the road ahead. For the
past 10 years, large output gaps in every part of the world ensured an
ample supply of labor. This logically translated into lackluster wage
growth and limited price pressures.
Now nearly a decade into the recovery, unemployment rates have not only
returned to pre-crisis levels, but in some instances are reaching record
lows. In the U.S., for example, you’d have to go back almost 20 years to
find an unemployment rate below 4% – and our baseline forecast for 3.5%
unemployment by the end of this year would be close to the record low of
3.4% in the late 1960s (which preceded one of the largest and longest
inflation episodes of the post-war era). In the U.K., unemployment is back
to a level last seen in the early 70s. And while southern Europe is still
lagging and has plenty of spare capacity, Germany’s unemployment rate is at
a multidecade low.
What happened to the Phillips curve?
Yet despite the tight labor market, wages have remained stagnant. This has
raised questions about the robustness of the so-called
– a cornerstone of most central banks’ frameworks which postulates that as
an economy gets close to full employment, wages and inflation should
accelerate. Confronted with a long period of subdued inflation, central
bankers are de-emphasizing the predictive power of the Phillips curve and
have remained extremely cautious in removing their extraordinary monetary
But what if the Phillips curve is alive and well, and hidden slack is the
reason for depressed wage growth? If this is the case, central bankers
could already be behind the curve and may be keeping rates too low for too
long. And even if this is not the case, a growing number of central bankers
appear comfortable with letting inflation run above their targets in order
to re-anchor inflation expectations at a higher level. The Federal Reserve
itself is forecasting inflation above 2% in 2019 (as measured by personal
consumption expenditure, or PCE, inflation), yet reaffirmed its view that
interest rates should be normalized at a slow and gradual pace. The dovish
bias of central banks is still solidly anchored.
Fiscal expansion and populism may stoke the fire
Add to tightening labor markets two potentially significant drivers of
economic change that we identified in our Secular Forum: fiscal profligacy
and rising populism. More and more countries have elected populist
governments that are introducing serious doses of fiscal expansion through
tax cuts and potentially increased spending – all at a time when one would
expect deficits to contract. In the U.S., for instance, the budget deficit
is growing despite very low unemployment and limited spare capacity in the
economy, leading one to logically wonder how real output will be able to
meet the increase in aggregate demand (see Figure 1). And higher demand
coupled with constrained supply is a textbook recipe for higher inflation.
The impact of populism doesn’t stop at higher public deficits. Both the
populist left and the populist right appear unified in their hostility
toward globalization and trade. U.S.-imposed tariffs have been limited so
far, and we believe even the proposed 10% tariff on $200 billion of
additional Chinese goods would have a measured impact on inflation; by our
estimates, it would raise core inflation by just 0.1% to 0.15% over the
next 12 months. The proposed tariffs on cars imported from Europe and Japan
pose a larger threat, in our view, potentially boosting inflation by as
much as 0.5%.
What about the tariffs’ longer-term impact? Much would depend on whether the U.S. can repatriate production from low-wage countries – a
dubious prospect, in our view, given near-full employment and the
administration’s restrictions on immigration. To gauge the potential impact
over the next five years, we ran simulations based on the Federal Reserve’s FRB/US macroeconomic models,
using different trade elasticities addressing the ability of the U.S.
economy to replace imports with domestic production. We found inflation to
be higher in all scenarios, with some persistence effect.
Last but not least, oil prices continue to climb as
OPEC struggles to increase output
amid production outages around the world (from Libya to Canada and
Venezuela) and the
sanctions on Iran.
Old patterns may not hold in a less-benign inflation outcome
While most markets and economists still have a benign view of inflation, we
see a material possibility of higher inflation that could have profound
implications, not just on real returns across assets, but also on market
volatility and portfolio construction. Many investors have grown accustomed
to the reliably negative correlation between stocks and bonds as they seek
to diversify and dampen volatility from portfolios of risky assets.
However, as we have pointed out before, this
correlation has generally only been reliable
when inflation is low or falling (see Figure 2).
To be sure, we believe high quality bonds will most likely provide an
effective portfolio hedge against the downside potential in risk assets in
the case of a recession, and
we see a recession as likely
over the secular horizon; however, as the stock market correction earlier
this year demonstrated, this approach might not work as well if inflation
fears are driving the risk-off moves. The correction in early February
began with a much higher-than-expected Consumer Price Index (CPI) print in
January, followed by above-consensus wage data in the first week of
February. At the same time, Treasury yields surged. If high quality bonds
could not hedge your portfolio, so the logic seemed to go, then the only
option was to sell your risky assets – a conclusion that resulted in
increased market volatility and drawdowns in risk assets.
Yet the market assigns a low probability to persistently high inflation, as
seen in the term structure of market-based measures of inflation
compensation, such as breakeven inflation (BEI). When comparing yields on
nominal Treasuries to those for Treasury Inflation-Protected Securities
(TIPS), for example, five-year BEI is now higher, at 2.21%, than 30-year
BEI, at 2.12%. This implies an expectation that inflation pressure will
rise in the near term, perhaps due to the impact of higher commodity
prices, near-full economic capacity or tariffs, but that inflation risk
will be much lower in the longer term.
Investor takeaways: Preparing for an inflation awakening
Although our baseline inflation outlook does not envision a rapid
acceleration over the secular horizon, we see greater inflation risk than
in recent years – and we believe many investors may be underestimating the
possibility of a longer-term inflation surprise. Such longer-term risk
could be very disruptive; as Figure 2 shows, it would imply a change in
correlation between major assets by depressing prices for bonds and
equities at the same time. This could be another rude awakening for
investors who may have assumed their portfolios were balanced.
While we believe investor portfolios in general properly account for growth
risks, we think investors should consider whether they are adequately
protected against rising inflation. Considering a standalone or combined
allocation to real assets – such as inflation-linked bonds, commodities,
real estate investment trusts (REITs) or other inflation-fighting assets –
is one way investors may seek to hedge their portfolios and potentially
enhance returns in the event that an inflationary regime emerges.
For more of PIMCO’s views on the complex drivers of inflation, please visit our inflation page.