With the U.S. unemployment rate down to 5% from a recessionary high of 10% in late 2009, some economists foresee building wage pressure, and with it, price inflation. Some even think the labor market could actually be tighter than the current 5% unemployment rate suggests. A Federal Reserve economist recently noted that discouraged workers that have left the workforce may never re-enter the labor pool. And if there truly is a skills mismatch between job openings and this so-called discouraged worker group, as many believe, the “hidden unemployed” may never find work under any conditions. The upshot would be more wage growth, more upward inflationary pressure, and, given where we are in the U.S. economic cycle, progress toward the Fed’s 2% inflation target.
But what if the prevailing thinking is wrong? Recent academic research by the Fed focused on a potential disconnect between a tightening labor market, higher wages and price inflation. According to the study, after the early 1980s, changes in labor costs had little or no predictive power for price inflation. The research concludes that “rising wage pressures might simply increase labor’s share of the fruits of production and squeeze profits without much effect on price inflation.” Another recent paper, authored in part by former Treasury Secretary Larry Summers, found “clear evidence that the effect of the unemployment gap on inflation has steadily decreased over time.”
What all this really means to the markets is that the ability of monetary policy authorities to reach the stated inflation target has diminished. This could provide a compelling reason for holding interest rates down to a lower level for a longer period than in past cycles.
We have seen recently that the weak level of global gross domestic product (GDP) growth has restrained corporate revenue growth. If labor’s share of income increases, it can mean only that profit margins will come under pressure. It would seem that companies that enjoy pricing power will thrive in this environment more than companies in highly competitive industries.
The notion that wage pressures won’t translate to higher levels of long-term inflation directly affects the bond market too. All other things being equal, long-term interest rates would be lower as inflation expectations decline. Treasury Inflation Protected Securities (TIPS) would likely generate lower returns over time. The Fed may still deem the economy strong enough to lift off from its zero short-term interest rate policy in December, but it will likely contribute to a flatter yield curve configuration as we move toward 2016.
In our view, the likelihood of interest rates soaring in reaction to rampant inflationary fear is low — completely dissimilar to episodes witnessed during the late 1970s and early 1980s. From a portfolio policy perspective, our central thesis suggests a modest underweight to core bonds, as we believe interest rates will generally trend higher.