The macroeconomic figures from the United States for the month of January surprised me mostly in positive terms. Good macroeconomic news is bad news these days because it means that the Fed needs to raise interest rates further. Count on a 0.25 percent interest rate hike in March and in May. In Europe, interest rates could go up much further. The market is counting on another 1.25 percent of interest rate hike, bringing the policy rate here to 3.75 percent by the end of this year. That looks firm, but remarkably, it is precisely here that wages are rising much more strongly than in the United States. Partly as a result, inflation here may become more persistent.
There is one common cause for the windfall economic development in Europe and the United States, and that is the weather. In Europe, it was so mild that partly because of this, natural gas prices fell sharply. In the U.S., it did not snow in the New York area for the first time since 1973, and since the Northwestern U.S. is a major core of economic activity, this is working its way into the macroeconomic figures. Also not helping is the fact that the focus of consumer spending is now on services. The service sector is labor-intensive, which explains the strong growth in hours worked in January and the service sector's better-than-expected purchasing manager numbers (55 instead of 50). Still, this seems to be a temporary effect, as the reality is that companies are cutting overtime and also temporary jobs.
Furthermore, the U.S. figures in terms of inflation and unemployment in January are also corrected based on the latest findings. Thus the inflation basket changes, usually it is gradual, but during the corona pandemic, the fluctuations were somewhat stronger. A little longer and the housing market determines half of U.S. inflation. Even the jobs report, which is little more than a narrow sample, contains so much noise that it only makes sense to look at the trend and not individual monthly figures.
The ultimate scenario everyone hopes for, of course, is that of a soft landing, a situation where inflation is not too high, not low, but just right, in equilibrium. This includes the possibility of avoiding a recession; even the Fed is trying to steer toward that. Windfall growth is also a setback in that context. After the current turnaround, the economy will eventually have to make a soft or hard landing. The likelihood of a hard landing increases if in hindsight it turns out that the Fed has stuck with tightening policy for too long.
There are several recessions that were in part caused by the Fed. In only three cases did a rise in the Federal Funds rate not be followed by a recession, with only 1995 qualifying as a soft landing. Still, Powell would prefer to avoid a recession, and he is trying to push for a soft landing. Complicating matters is that interest rate hikes take 12 to 18 months to have their full impact. Time will tell, but if inflation moves quickly toward 2 percent, Powell will push for a pause.
Whereas Powell signaled disinflation in his last comments on the interest rate decision, recent developments seem to have caused the market to greatly underestimate that same disinflation. Still, it remains striking to what extent base effects on the inflation rate are barely taken into account. Indeed, for the time being, those base effects will cause inflation rates to fall sharply. Furthermore, an increasing portion of inflation consists of rising rents, which are derived from housing market trends. While there are some signs of stabilization in the housing market, such a strong positive contribution is extremely unlikely for the next few years.
Month-on-month, real rents are already falling, but that translation to the inflation rate may be some time away. What history shows is that a sharp rise in inflation is almost always followed by an equally rapid fall in inflation. Base effects dominate the first half of the year, in Europe through August. Inflation rates below two percent or even deflation are quite possible this summer.
Eventually, inflation rates will return to above two percent in the coming years, but central bankers can probably live with that in the context of financial repression, or at least they won't put up with a severe deep recession with millions out of work to keep inflation falling further. That means that priced-in inflation expectations are still too low in the long run and thus an attractive alternative for investors. Priced-in inflation expectations are derived from the breakeven price of a bond. At this breakeven level, it does not matter whether a regular government bond is purchased or an inflation-linked bond (in the US TIPS: Treasury Inflation-Protected Notes). The breakeven is simply the difference between the nominal yield on a government bond (now 3.94 percent for 10 years) and the real yield on an inflation-linked bond of the same maturity (now 1.56 percent). The difference (2.38 percent) is then called the inflation expectation, but it actually has hardly any predictive value. No one in the real economy calculates these figures. Then it gets interesting because while participants in the real economy calculate with higher inflation rates (which are a much better predictor of future inflation) we thus do not see this reflected in financial markets. Real interest rates on TIPS have not been this high since 2010. Even for retail investors, it looks like an attractive alternative to equities. At the time when inflation averages 5 percent over the next 10 years, investors get a return of 6.56 percent.
Moreover, again, the inflation-linked market is not that old. The first TIPS bond was issued in 1997. There are now 11 years for which data are available on inflation over the full 10-year term. In seven cases, the inflation rate was subsequently underestimated. Perhaps people are staring blindly at the 2 percent target, but even the Bundesbank experienced an average inflation rate of 3.3 percent during the time it was allowed to set monetary policy in Germany. Probably at this point, future inflation is still underestimated and people think we are returning to pre-Corona levels. What does remain is a perhaps somewhat curious conclusion. Inflation first goes down more sharply than what the market is currently counting on, and the moment the Fed can happily conclude that the 2 percent inflation target has been met, the first surprises that inflation will rise above 2 percent seem like a matter of time. But the moment the market believes the Fed has met its inflation target without causing a recession, the Uber-Goldilocks scenario quickly takes hold. Only it requires quite a balancing act to get there. We probably have to wait until the May and June inflation figures to get more clarity.
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