Worried Inflation Will Push Interest Rates Higher Than You Expect? Don’t Be.

On February 5, the Dow Jones Industrial Average shed 1,600 points in afternoon trading, before ending the day 1,175 points down (minus-4.6%) – after losing 666 points (the number of the Beast!) on the previous trading day. America’s bellwether index has now lost 7% in just two days and given up all its gains in 2018.

Asia’s stock markets followed in the downdraft. Japan’s Nikkei Index slumped 2.25% on February 5 and another 4.7% the next day. Over the two days, Hong Kong's Hang Seng Index and Singapore's Straits Times Index fell by 6.1% and 4.9%, respectively, while China’s CSI 300 slid by 2.9%.

“There is little evidence that the risk of persistently strong wage growth has increased. We see inflation only creeping higher”

But the proximate cause was not a weakening US economy or a banking crisis. On the contrary, the trigger was new evidence that America’s GDP may accelerate more strongly than anticipated. The latest jobs report had non-farm payrolls increasing by 200,000 in January, higher than the expected 180,000. The news coincided with the yield on ten-year US Treasury bonds spiking to 2.8%, from 2% or lower in the past two years.

Market participants put two and two together, and started selling on the fear that inflation may surge as employers are forced to pay more to retain or recruit workers, even as US tax cuts leave more money in their pay packets. The US Fed might then raise interest rates higher and faster than it had been signaling, further raising business costs and cutting into corporate earnings. Programmatic trading, sell orders activated by algorithms, did the rest.       

Time to Rethink the Budget?               

Is it time for CFOs to redo budgets and forecasts, penciling in higher interest rates and thus higher debt repayments and other costs? Not yet, according to an analysis by global advisory Oxford Economics.

“For the advanced economies to record a sustained bout of above-target CPI inflation, we would need to see wage growth take off,” the firm concludes in a new report. “But there is little evidence that the risk of persistently strong wage growth has increased. We see inflation only creeping higher.”

If so, that means US interest rates will remain accommodative in the short to medium term. The Fed’s median projection for 2018 is 2.1%. If that is the assumption you as CFO plugged into the current budget, you should be OK. Moderate rate rises in the US means moderate increases in Asian economies too, particularly in Hong Kong, whose local currency is pegged to the US dollar.

What’s behind Oxford Economics’ confidence in this view? “While some temporary factors holding back wages, such as ultra-low inflation, may now be subsiding or have run their course, other more structural factors such as automation and offshoring remain and could even intensify,” it argues.

The Philipps curve, a single-equation empirical model that posits that decreased unemployment correlates with higher rates of wage rises, remains flat, notes Oxford Economics. That may change as spare capacity in the US labor force dwindles. But the advisory firms believes that “unemployment rates, relative to past lows, may be understating slack, implying that any steepening of the Phillips curve may therefore not be imminent.”

What about external triggers of inflation such as a surge in oil or commodity prices? That can happen, but “it is not in our baseline,” says the report. Crude oil has recovered from it’s the US$30-per-barrel lows in 2016 to around US$60 recently, but prices are still far off the US$130 high in 2008.    

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