Low inflation in the US could be about to change, sending us on a 50-year cycle, explains Mark Rider.
If there’s a strong upswing in US inflation then investment performance, economic activity and financial conditions worldwide could radically change.
The US economy accounts for nearly 25 per cent of world gross domestic product and around half of the value of global sharemarkets, and so what happens in the US has impact far beyond its own shores. Inflation – the rate of increase in US goods and services prices – is a central force in shaping the economy and markets.
So the attention of investors, economists and financial markets’ experts is fixed on the US inflation rate. Currently the rate is very low and has been for some time, just as it was in the early 1960s, and looking back to what happened then is a cautionary tale for our immediate future.
Are the 1960s about to be repeated?
For most of my lifetime, US inflation has been on a round journey from stable, low inflation in the 1950s and the first half of the 1960s, to high inflation and now back to stable sub-2 per cent inflation.
It could be that in early 2018 we are in the same position that our parents and grandparents generation faced back in 1965: that year inflation was very low in the US as it had been years prior, but that changed very quickly.
US inflation since 1950
Sources: Bloomberg, ANZ Wealth
The chart above shows the pickup in inflation, wages and bond yields in the second half of the 1960s before a further rise in the 1970s and early 1980s. We see some parallels between now and the mid-1960s that provide some context on how a period of low inflation may end.
When inflation is falling, or low, as it has been since the early 1980s, it pushes interest rates down and the future value of cash flows up and, in turn, pushes the value of assets higher. The dramatic acceleration in US inflation that started in 1966 was a major trend break from the stability of the preceding decade.
In the mid-60s, as now, US unemployment was close to 4 per cent. The steady rise in inflation from 1.5 per cent to 6 per cent (from 1966 to 1970) coincided with sustained unemployment below 4 per cent over the same period. Wages growth gave the first inkling of a change as it accelerated in 1965, doubling from around 3 per cent to 6 per cent by the end of the 1960s. Currently, wages are only trending up relatively slowly.
Little tolerance for inflation these days
And that is one of the major differences between then and now. In the 1960s every 1 per cent fall in the unemployment rate saw wages growth rise 1 per cent. Now the relationship is very weak with a rise in wages of around 0.1 per cent for the same drop in unemployment.
US government policies to make the economy grow are now, if anything, more supportive of sustaining low unemployment. The US central bank, the US Federal Reserve, has made extreme efforts to grow the economy in the aftermath of the global financial crisis (2007-08) with very low interest rates. And the current government’s fiscal policy looks the same as in the late 1960s, with President Donald Trump’s tax cuts and increased spending adding 2 per cent of gross domestic product to the budget deficit, in line with former president Lyndon Johnson’s Vietnam War-related surge.
The 1960s showed that a dramatic change in trend inflation is possible, but it’s no accident. An economy that is pushed too hard for too long is unlikely to ignore the laws of supply and demand indefinitely.
Unemployment below 4 per cent for half a decade in the 1960s set the scene for a sustained surge in inflation. While unemployment has only now just fallen to 4 per cent, with both monetary and fiscal policy supportive of growth it is likely to move lower in the coming year.
While inflation remains low now, despite dropping unemployment, this is not a reliable pattern. While there may be some delay, lowering unemployment will, eventually, lead to higher wage growth.
One of the key differences this time around is that the US Federal Reserve will act if this situation occurs due to its 2 per cent inflation target sustained low unemployment with accelerating wages and inflation is unlikely to be tolerated for long. However, while the rise in inflation may be more cyclical than structural, the flip side is a more aggressive change in policy to slow the economy.