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Inflation and Deceleration


In early April there was concern the US economy might founder as job growth kept disappointing economists. These puzzled analysts had been predicting a robust upturn in jobs since last summer, oblivious to a rapid structural change during which weak job growth was to accompany strong growth in gross domestic product.

But just as economists threw up their hands in despair, payroll jobs surged for two months, triggering a sea change in perceptions and shifting concerns from economic weakness to inflation.

The problem for the equity markets is that current economic conditions may be as good as it gets. Job growth has picked up, GDP growth remains healthy and inflation is relatively subdued. Unfortunately, markets look ahead, focusing on the significant risk that things will get worse in terms of inflation and economic growth. These concerns are valid but others are overblown.

During most of the 1990s, big economies took turns going into recession, preserving global overcapacity and keeping inflation in check. Only in 1994 and 1999-2000 did they expand at the same time. Not surprisingly, that was when US import prices rose, adding to domestic inflationary pressures, and the Federal Reserve raised interest rates aggressively.

Remember the late 1990s argument that strong productivity growth had killed inflation? Today, we are hearing similar soothing noises from some quarters. But if the Fed truly believed that, it would hardly have raised rates repeatedly in 1999-2000.

Research shows it was mostly falling import prices that kept inflation low in the late 1990s. The problem is that after 20 years of pre-emptive action against inflation, the Fed has shifted to a wait-and-see policy. As we move into another synchronous global expansion, boosted by the boom in China, rapid demand growth is soaking up global capacity faster than suppliers had anticipated, reinforcing yet another upswing in US import prices.

As a result, the Future Inflation Gauge (FIG) developed by the Economic Cycle Research Institute (ECRI) has been trending upwards since the end of 2003. This is a concern because the FIG, a composite leading index of inflation, is a good measure of underlying inflationary pressures. Unlike the much-touted output gap between potential and actual GDP, a measure of inflationary pressures that failed miserably in the late 1990s, the FIG has an excellent track record. If it continues in an upswing, inflation is likely to climb significantly, as are bond yields, in the absence of forceful pre-emptive Fed action.

Meanwhile, we are on the cusp of a transition from the acceleration to the deceleration phase of the recovery. This is clear from the growth rate of ECRI's Weekly Leading Index (WLI), a leading indicator of turning points in economic growth. WLI growth is finally moderating after peaking last summer, suggesting that US economic growth will follow the same pattern.

As the economy's rate of growth eases, so should corporate earnings growth, justifying a lower price-earnings multiple for equities. Higher interest rates are also likely to induce multiple compression.

The other issue looming is the rise in geopolitical uncertainty. Some worry about instability in Iraq and a change in the US administration. There are also fears the Chinese economy may face a hard landing as the authorities try to rein in the boom. And there is concern that high oil prices may choke off economic growth or boost inflation.

But even as an inflection point in economic growth, rising inflation pressures and growing perceptions of risk compress the price-earnings multiple, corporate earnings should keep rising as the economy continues to expand. The upshot will be a tug of war between rising earnings and the forces depressing the market's price-earnings ratio.

The trends in the FIG and WLI growth are cause for concern for stock prices. But the risk that geopolitical events, along with high oil prices, could derail the US economic expansion is minimal.

Given the dismal real-time recession-forecasting record of econometric models, few are aware that recessions are predictable. But one has to use effective tools such as the WLI, which correctly anticipated the last two recessions as well as the recoveries that followed and currently sees no recession on the horizon.

The message from the WLI is that while growth may slow, the recovery remains resilient and nothing short of a huge shock can derail it. Notwithstanding fears about heightened event risk, a new recession remains highly unlikely this year.

The author, Anirvan Banerji, is director of research of ECRI and co-author of "Beating the Business Cycle: How to Predict and Profit From Turning Points in the Economy", to be published tomorrow by Doubleday.