The expectation that inflation will remain low could end up masking the signals of overheating economies—and actually push inflation higher.
Over the past five years, when framing the inflation outlook, consensus almost always forecast that inflation would eventually return to central banks’ goals of around a 2% annualized increase. Yet most inflation forecasters were serially disappointed as inflation remained persistently low. Former Federal Reserve Chair Janet Yellen distilled their frustration when she called low inflation in the U.S. a “mystery” just a little over a year ago, in September 2017.
However, since October 2017—when core inflation grew at an annualized 1.1% pace for the G3 regions of the U.S., euro area and Japan—core inflation has risen to 1.4%, near post-financial crisis highs. My colleagues and I at Morgan Stanley Research expect core inflation across the G3 to move higher, with a further rise in the U.S. and a more pronounced uptick in the euro area and Japan, decisively breaking out of the post-crisis doldrums.
Some investors may ask why we believe that this inflation uptick is real and sustainable. Two factors anchor our growing confidence in this inflation outlook: the inflection in wage growth and a changed macro backdrop.
As we highlighted recently, wage growth in the G3 is seeing synchronous improvement and stands at multiyear highs across all three geographies. We expect wage growth to rise further in the U.S. and to remain well-supported in the euro area and Japan.
In our view, wages are signaling that labor, as well as other factor markets, are starting to tighten materially. Evidence of stretched resources in the economy further strengthens our conviction that risks to inflation are no longer skewed to the downside.
We’ve made the case that the macro backdrop today is very different from 2012-2016, which was characterized by deleveraging, a risk-averse private sector and below-trend aggregate demand. Nominal growth was sluggish, reflected in expectations for lower returns, which depressed private capital spending.
This made the global economy a lot more susceptible to deflation vs. inflation risks. Since 2017, the economy has moved beyond the deleveraging phase; private sector risk appetite has improved, and aggregate demand growth is now above trend. The clearest sign of change is the pick-up in global capital spending growth. Even though 2017 marked the inflection point in the macro environment, the collective weight of idiosyncratic factors in areas like health care and telecom services meant that inflation didn’t start to rise until October 2017.
In our base case, above-trend growth continues to draw down economic resources, pushing up capacity utilization rates and wage growth, which translate into higher inflation for core goods and services.
Therefore, core inflation in the G3 will rise closer to the respective central banks’ goals, with a more pronounced uptick in the euro area and Japan than in the U.S., which is already close to target. By the fourth quarter of 2019, we expect annualized core inflation to reach 2.2% in the U.S., 1.8% in the euro area and 1.2% in Japan, up from their current 2.0%, 1.0% and 0.4%, respectively.
G3 Core Inflation to Rise Above Post-Crisis Highs
In fact, we think that the risks to the inflation outlook are skewed to the upside, particularly for the U.S. While most would take comfort from well-anchored inflation expectations, work done by our U.S. economics team actually suggests the opposite: Low inflation expectations readings could predict higher inflation.
Low inflation expectations no longer hold down inflation, and actually may boost economic growth if policymakers respond by keeping monetary policy looser than warranted, which then drives inflation up.
Interestingly, Fed Vice-Chair for Supervision Randal Quarles alluded to this in a speech last week, saying that he expects that the dampening effect of low inflation expectations on inflation will not last: “Anchored inflation expectations might mask the inflation signal coming from an overheated economy for a period, but I have no doubt that prices would eventually move up in response to resource constraints.”
With inflation set to rise toward their goals, central banks in developed markets are likely to continue to withdraw monetary accommodation. Moreover, the strength in wage growth supports increasing confidence in the inflation outlook. This has shifted the trade-offs for the central banks, and also means that the bar for changing course on tightening is higher than earlier in the cycle.
As the uptick in inflation is likely to be more pronounced in Europe compared to U.S., our rates strategists see select opportunities in European inflation-related instruments as a way to best capture this theme. Reflecting this shifting inflation dynamic and central banks' stance, our cross-asset strategists believe that volatility will continue to rise across all asset classes.