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In the current market, there is a belief that US inflation will continue to decelerate while real output remains strong. However, it is equally likely that inflation will stabilize at a rate approximately 2 percentage points higher than the Federal Reserve’s goal of 2% per year. If this scenario occurs, short-term interest rates could remain the same or even increase, leading to higher long-term yields and lower valuation multiples. This could potentially impact asset prices.
The writer is publisher of The Overshoot research service and co-author of ‘Trade Wars are Class Wars’
The current slowdown in US inflation seems counterintuitive. Inflation has already decreased from around 10% per year in the first half of 2022 to approximately 3% per year. This slowdown has occurred alongside strong growth in real consumer spending and the creation of numerous jobs. Given these factors, it may seem pessimistic to suggest that inflation won’t smoothly decelerate to the Fed’s target of 2%.
However, the deceleration in inflation can be attributed to temporary disruptions associated with the pandemic and geopolitical events like Russia’s invasion of Ukraine. These events disrupted the supply of goods and services, leading to price increases. As conditions normalize, many prices have stopped rising or even declined.
Despite these fluctuations, there is a consistent underlying trend of accelerating price pressures. To understand where these pressures may settle in the future, it is important to focus on wage trends, as wages are a significant source of financing for consumer spending. Since 1929, the average American worker’s hourly wage has grown approximately 1.6 percentage points faster than the PCE price index each year. Only 17 out of the past 92 years have seen wages grow at least 3 percentage points faster than prices, with only five instances occurring after 1956. Between 2000 and 2019, average hourly wages consistently grew just 1 percentage point faster than prices each year. Wage growth surpassing 4 percentage points faster than prices has been rare, usually coinciding with significant events like the Great Depression, wartime, or productivity booms.
However, the latest data suggests that US wages are currently growing at a rate of about 5% per year. Persistent wage growth implies that interest rates may stay higher for a longer period unless consumers reduce their spending or real output per worker significantly increases.
The Federal Reserve’s chair, Jay Powell, acknowledges the importance of wages and their relation to inflation. He has expressed the desire for wage growth consistent with 2% inflation, highlighting the issue’s significance. This focus on “softening” the job market through higher interest rates poses a risk that rates may not decline as quickly as anticipated, potentially impacting asset valuations.
Looking at market prices, futures in Sofr currently suggest that short-term interest rates will decrease to 3.5% by the end of 2025, while break-even inflation rates indicate an annual price increase of 2% for the next three decades. Credit spreads are tighter than in 2019, and stock earnings multiples have risen. Relative to bonds, prospective returns on stocks are at their lowest since mid-2007, reflecting extreme optimism about future profit growth. However, this optimistic outlook depends on inflation returning to 2% and wage growth decelerating accordingly, without any negative impact on real output.
Although many Fed officials may not want to intentionally cause an economic downturn due to inflation stabilizing around 4% per year instead of their target of 2%, this lenient approach is not currently factored into market prices.
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