Higher Inflation Could Be A Game Changer

January 16, 2018

Higher Inflation Could Be A Game Changer

  • Inflation has finally reached the FED’s target of 2%.
  • Employment and GDP levels indicate we are in the late part of the economic cycle.
  • Will the FED lose control over its monetary policy?



Introduction

Global economies are all finally doing very well, or at least just well. You can’t expect economic skeletons like Europe to do very well. Nevertheless, monetary policies across developed markets are still supportive.

Supportive policies, from the ECB still buying bonds on the open market, to the BOJ buying ETFs, and the U.S. lowering taxes, indicate that all these economies would be very different without supportive policies.

What would you do if you were a politician and could help the economy, lower unemployment while inflation remains low? For example, Chicago Fed president Michael Evans is urging the Fed not to increase interest rates as long as inflation is low.

This is very short term thinking but shows how the game changer will be inflation and, unfortunately for Evans, we are starting to see the first signs of it. Last Friday, the U.S. Labor department published that inflation was 2.1% over the last 12 months showing how inflation has finally reached, and even surpassed a bit, the FED’s target inflation rate.

My fear is that central banks could easily lose control over inflation which would create stagflation. Stagflation is when there is no economic growth alongside inflation, something that’s very difficult to manage. But, let’s first see what is going on.

Inflation Environment

One important thing has happened recently, the unemployment rate has gone below the natural unemployment rate. In such an environment, it’s really hard for companies to hire employees and, therefore, higher wages are imminent but there’s also little room from growth. How can a company grow if it can’t hire employees?

Figure 1: Unemployment rate (blue) and natural unemployment rate (red). Source: FRED.



As you can see above, when the unemployment line crosses the natural unemployment line, the economy gets into the late part of the cycle and much closer to a recession because higher input prices make fewer projects profitable and there is less growth.

Further, the actual GDP has crossed the potential GDP. This usually happens when the economy is overstretched. This again limits future growth and indicates that the late part of the economic cycle is here.

Figure 2: The actual GDP crossed the potential GDP. Source: FRED.

Things In Europe Are Going A Bit Too Well

The European economy grew around 2.4% in 2017, which is more than the 1.7% expected by the ECB. Inflation in the Euro area is still low at 1.4% for December 2017 but if you walk around, you will see that most shops look for employees and that the unemployment rate has significantly fallen, from an average of 12% to around 8%.

A problem might arise when the ECB isn’t able to stimulate the environment because of rising inflation and because there will be no place from where the growth will come. The European labor market is much less flexible than the U.S. and the natural unemployment level is much higher. Additionally, higher interest rates will make it extremely difficult for countries and corporations to pay their financial dues. All will probably lead to more easing and higher inflation.

All the above happenings are confirmed by the price of gold. As more and more investors seek protection from what might happen in the future, we see gold slowly rising.

Figure 3: Gold prices are up significantly in the last year. Source: Bloomberg.

Now, these are all short term influences indicating we are in the late part of the economic cycle and that higher inflation and higher interest rates could dampen growth and lead to a recession.

However, if we listen to smarter people then ourselves, inflation and higher interest rates could lead to extremely big problems. Ray Dalio recently started with warning the world that even if we might not see a huge crisis in the future, the debt burden will heavily weigh of future economic growth and financial markets.

I’m discussing inflation here because as time goes on, it becomes more and more difficult for central banks to balance the need for higher interest rates to limit inflation and low interest rates to keep asset prices high, and strong consumer confidence and economic growth alive. As the economy is cyclical, the party cannot go on forever.



The problem is exacerbated by the fact that by keeping interest rates low, central banks can’t really repeat what they did in 2009 and afterwards to pull their economies out from a possible depression which creates the main long-term risks for the global economy. To put it in economic words: Next time it might really be different.

What Does This All Mean To You & Your Portfolio?

According to Dalio, your investment returns will be around zero for the next 10 years because higher interest rates will lower asset values and corporate cash flows while possible lower interest rates will be there to counteract for economic slowdowns further lowering your returns. If you are close to retiring, Dalio advises to save up what you have.

This means that now is the time to really start thinking for yourself. I’ve discussed how the risk reward situation is extremely different even among blue chip stocks. So this might be the best time ever to lower the risks of your portfolio and find extremely cheap hedges in order to be prepared for everything.



By Sven Carlin FED Inflation Interest Rates Investiv Daily Share: