Investors are looking forward to this week's pronouncement from the U.S. Federal Reserve. But what really matters is what inflation has to say.
Any broad uptick in consumer prices in coming months will spur the Fed to aggressively hike interest rates as a way to put a lid on inflationary pressures. That would place new pressure on today's record-setting stock markets.
Low interest rates have been one of the key forces propelling shares higher in recent years, because puny bond yields tend to drive money into stocks in pursuit of a better return. If interest rates rise more strongly than expected, stocks will face new competition from bonds, and Wall Street will feel the squeeze.
To be sure, most shareholders appear unfazed by the prospect. Years of comatose inflation have created a new normal in which people have come to take ultralow interest rates as the usual state of affairs. But there are early signs the situation is changing around the world, especially in the United States.
The Fed is expected to hike interest rates for the third time this year on Wednesday. The consensus forecast is for three more hikes in 2018, but some observers, including John Higgins at Capital Economics, say four increases of 0.25 percentage points each is more likely.
Mr. Higgins predicts the benchmark 10-year U.S. Treasury bond will end 2018 with a 3-per-cent yield – low by historical standards but more than double where the yield stood 18 months ago. If so, stocks are likely to plateau over the year ahead before falling in 2019 as "cracks start to appear in the U.S. economy," he says.
Nobody wants a serious recession, of course. To avoid triggering one, the Fed is likely to move cautiously to unwind the extraordinary stimulus it delivered during the financial crisis. If inflation stays low, policy makers should be able to take their time in returning conditions to something approaching normalcy.
The danger is if inflation starts to ramp up more quickly than expected. Broad measures of the current financial environment, which take into account everything from exchange rates, to the money market, to debt and equity values, show that money has rarely been easier to come by than it is right now. The Chicago Fed National Financial Conditions Index is hovering at its lowest point since the mid-1970s, indicating credit is unusually easy to obtain, while risk and financial leverage are abnormally high. (Elevated numbers in the index indicate tighter than average conditions, while low readings point to easy money.)
Loose financial conditions tend to breed inflation. While consumer prices outside of food and energy are still only inching upward, at about 1.8 per cent a year, inflationary pressures appear to be building beneath the surface.
The Underlying Inflation Gauge, compiled by the New York Federal Reserve Bank, attempts to monitor those pressures by tracking a broad array of prices, including stock and bond values, as well as variables such as the unemployment rate. It has headed strongly upward in recent months, indicating inflationary momentum is picking up speed. The most recent reading, for October, estimates consumer prices are rising at between 2.25 per cent and 3 per cent a year, well above the 2-per-cent level that makes policy makers comfortable.
Inflation will be "the big story" of 2018 and could be "a global game-changer for stock and credit markets," according to an outlook by Bank of America Merrill Lynch. It sees mounting inflationary pressures not just in the United States but also in the euro zone and China. Even in Japan, which has suffered two decades of deflation, or constantly falling prices, inflation is likely to stage a resurgence and hit 1 per cent by mid-year, Bank of America says.
The bank's analysts expect modest gains by U.S. stocks in 2018, but they also underline how unusual this situation would be: "Stocks are expected to outperform bonds for the seventh consecutive year in 2018, a track record not seen since 1928."
One of the biggest risks Bank of America sees is the possibility that U.S. tax reform will be enacted and fuel the inflationary heat in 2018. "With the U.S. already at full employment, the economy could overheat, triggering a faster rate-tightening cycle and raising the risk of a policy mistake by the Federal Reserve."