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Trader Fred DeMarco, center, and specialist Anthony Rinaldi, right, work on the floor of the New York Stock Exchange, Thursday, Feb. 8.Richard Drew/The Associated Press

Two weeks ago, the mere suggestion that wages might be rising a whisker faster than expected in the United States was enough to drive global stock markets into a panic over the possibility of higher inflation ahead.

This week, the mood abruptly shifted. Investors around the world yawned at a higher-than-expected reading on U.S. inflation and decided to treat themselves to a rally.

The wild swing in sentiment may simply be the result of Mr. Market's notoriously unstable temperament. More likely, though, it reflects the complicated nature of inflation. Too little is worrisome, so is too much. Like Goldilocks' porridge, the goal with inflation is to achieve a temperature that's just right.

Markets have apparently decided that the inflationary pressures we're witnessing still leave us solidly in Goldilocks territory. For now, they're correct.

The question is whether we will stay in this happy place.

Here's the problem: Central bankers typically aim for an inflation rate of around 2 per cent, a level that is in keeping with strong economic growth and a stable job market. Since the financial crisis, policy makers have often been unable to hit this target. They've been stymied by persistent joblessness and unused factories and mines. The large amount of slack in the economy has put a lid on price increases and kept inflation stubbornly below target.

Recent numbers suggest North America is finally emerging from this long malaise. In Canada, where the consumer price index (CPI) is rising at 1.9 per cent year over year, and in the United States, where the headline number is at 2.1 per cent, inflation is now ticking along at nearly exactly the 2-per-cent target. Unemployment in both countries has tumbled and both economies are growing at a reasonable clip. This is all good news.

So why have markets been so volatile in their reaction to inflationary tremors? It comes down to their assessment of what happens next.

Over the past several years, rock-bottom yields on bonds and savings accounts have provided next to no competition for stocks. As a result, equity investors have enjoyed one of the best bull runs in history. But signs that inflation is returning to more normal levels suggest that other interest rates may also be rebounding to more normal levels. If so, stocks will no longer be the only game in town.

In the United States, the yield on the benchmark 10-year Treasury bond has soared to around 2.9 per cent, its highest level in four years. That is still low by historical standards and not an obvious reason for concern, especially if corporate earnings continue to be strong and future increases in rates occur at a measured pace. However, signs of a more normal economy provide lots of reason to worry about disruptive surprises ahead.

The biggest risk for investors is the possibility of a policy error. Jerome Powell, the new chair of the Federal Reserve, has served as a governor of the world's most powerful central bank since 2012, but he has been in the top job for a mere two weeks. He faces an economy that is headed into unknown territory because of the massive tax-reform package recently passed by Congress.

Governments usually deliver a bounty of goodies only when joblessness is high and businesses are begging for a boost. Instead, U.S. tax reform will unleash a powerful wave of stimulus on an economy that is already operating close to full capacity, with unemployment at a 17-year low. The new tax rules are likely to send demand soaring at the same time as the supply of new workers is dwindling.

Too much demand competing for not enough supply amounts to a textbook formula for inflation. In theory, the Fed should now lean against those inflationary forces by raising rates to dampen demand. But how fast and by how much should it hike?

It's a tough question, especially for a new Fed chief operating in the chaotic environment of U.S. President Donald Trump's Washington. If Mr. Powell mistimes things, by being too slow or too fast with rate increases, inflation will once again become the obsession of stock markets.

For now, the futures market indicates investors are expecting him to hike rates three times this year. This would bring the key Fed funds rate to 2.25 per cent, still low by historical standards and not likely enough to derail any economic momentum.

But those expectations could be upset by a second risk: the possibility that inflationary forces are already stronger than generally realized. In recent months, there has been a surge in ISM prices-paid indexes, which measure price increases across large swaths of the U.S. economy. Producer prices for core consumer services also jumped in January, according to numbers released this week.

While most conventional gauges peg current inflation at around 2 per cent, the Underlying Inflation Gauge (UIG) developed by the Federal Reserve Bank of New York says the inflationary trend is rising quickly and now running as high as 3 per cent a year.

The UIG looks at factors beyond prices, such as financial and industrial gauges, and is supposed to "provide a more timely and accurate signal of turning points in inflation" than conventional measures, according to the New York Fed. If it's right in detecting growing inflationary forces, there would seem to be a case for raising rates at a pace faster than many market participants currently expect.

However, today's situation is unusual because some of the traditional economic relationships no longer appear to apply as they did in the past.

Falling unemployment, for instance, used to reliably signal more inflation ahead as employers raised pay to attract increasingly scarce workers. But that relationship, known as the Phillips curve, has been growing weaker, perhaps because of businesses' increasing ability to move production to lower-cost locations.

Meanwhile, an aging population seems to be creating unusually strong demand for income-producing assets. A recent working paper from researchers at the Bank of England speculates that this growing appetite from the gray-haired set for safe bonds and similar investments will keep interest rates stuck at far lower levels than in the past.

The upshot is that forecasters are now divided about what lies ahead. The team at TD Bank sees no great reason to worry and expects the Fed to take a gradual path to hiking rates. In contrast, Allen Sinai at Decision Economics expects inflation to climb to between 2.5 per cent and 3 per cent by late 2019, with yields on the benchmark 10-year Treasury bond leaping as high as 5 per cent, a big move from their current level.

If rates do jump as high as Mr. Sinai expects, investors might decide to respond to much higher bond yields by moving money out of stocks. At the very least, higher bond yields would shatter what traders call TINA – the notion that There is No Alternative to buying stocks. It would be replaced by what Ben Inker of GMO LLC calls TIAOA – There Is An Okay Alternative.

Even if rates don't surge, there's still a third danger for investors: The possibility that a stronger economy and higher inflation will drive much faster growth in wages, depressing companies' profit margins, especially in the United States.

Look back over recent decades and you see a bob-and-weave act between the share of the economy that goes to workers and the share that goes to companies' bottom lines – when one goes up, the other goes down. Since 2014, the share of U.S. GDP that goes to workers' pay has been rising, although it is still at one of its lowest levels in the past half-century. If workers' pay were to continue climbing, especially at a pace above inflation, corporate profit could get crimped at just the same time as bonds become a more attractive alternative for investors.

This is still just speculation, of course. Despite the recent fuss about rising wages in the United States, paycheques are growing at much the same pace as they did two years ago, according to the wage-growth tracker developed by the Federal Reserve Bank of Atlanta. But the trend is something to watch. What finally brings the great bull market of the past decade to an end may not be a blast of bad news, but too much good news on rising wages.

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