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Data dependency is back in vogue with central banks this year, which means their misguided fear that wage growth and low unemployment caused the spike in inflation will finally be put to bed. Yes, the Phillips curve is dead.
The exogenous shocks of COVID-19 and the Russia-Ukraine war caused the spike in inflation in 2022, forcing central banks to increase interest rates aggressively to curb inflationary pressures and maintain financial stability. Yet, there are several factors investors need to keep an eye on this year that may not only stop central banks from raising interest rates further, but lead them to cut rates sooner than consensus estimates.
A major one is dramatically declining inflation. Although inflation is viewed, generally, as a negative economic outcome, persistently low inflation, or deflation, can also be concerning. That’s because it can lead to lower economic growth and a falling standard of living.
The U.S. Federal Reserve Board and the Bank of Canada (BoC) have a target rate of inflation of 2 per cent. If inflation remains persistently below that level, they may cut rates to stimulate demand and boost inflation. Currently, six-month non-seasonally adjusted annualized consumer price index data – 0.2 per cent in Canada and 0.4 per cent in the U.S. – suggest that headline inflation data is well below the 2 per cent target and very close to deflationary levels. And that’s before the full effects of the most aggressive monetary tightening have been felt.
How quickly we forget the concern of the pre-COVID-19 era, in which deflation and decades of inflation below the central banks’ target of 2 per cent gave rise to the populist movement.
Slow economic growth is another reason the Fed and BoC may pivot this year. Economic growth is an essential indicator of an economy’s health. If economic growth slows, they may cut rates to stimulate demand and support economic activity.
Then, there’s financial market instability. The excessive levels of debt accumulated over the decades, with a significant increase since the start of the pandemic, and the ensuing rapid interest rate hikes mean financial markets could soon be on the verge of a credit crisis, as was experienced in 2008. In turn, the Fed and BoC may cut rates to support financial market stability and mitigate the potential negative economic impact.
The final and most controversial reason why central banks may stop raising interest rates and even cut them in 2023 is the abandonment of the false premise that low unemployment causes inflation. Many experts assume wrongly that low unemployment leads to high inflation, as more people with jobs means more demand for goods and services, which puts upward pressure on prices.
This relationship, known as the Phillips curve, posits that unemployment and inflation have an inverse relationship. So, as unemployment decreases, inflation increases, and vice-versa. Central banks and strategists on Wall and Bay Streets assume, incorrectly, that low unemployment and growth in the private sector led to the spike in inflation. There are several reasons why this may be the case:
- Other factors can influence the relationship between unemployment and inflation, such as capacity utilization, credit availability, and productivity level in an economy. (We forget the record low unemployment before COVID-19 did not lead to a rise in inflation.)
- The Phillips curve is based on the theory of demand-pull inflation, which states that an increase in aggregate demand leads to a rise in prices. However, other inflation theories suggest that prices may increase for different reasons, such as supply shocks or cost-push inflation. The inflation spike is not the result of a white-hot economy resulting from private sector aggregate demand but from random exogenous shocks.
- Central banks may need to focus on adequate measures of unemployment. The divergence between the two key U.S. labour market surveys – the establishment and the household survey – implies that the job market is not as tight as many assume. A recent study from the Philadelphia Federal Reserve concluded that reported job growth of over 1.1 million might only be 10,000.
- Central banks assume wrongly that low unemployment leads to high inflation because they may need to consider monetary policy’s role in shaping the relationship between unemployment and inflation. Monetary policy, which has long and variable lags, influences the supply and demand of money and credit in an economy and can impact the relationship between unemployment and inflation significantly. High interest rates slow capital formation and investment, which hinders the adjustment process in inflationary periods where more supply is needed. Correlation is not causality.
Recent economic data suggest that wage growth is declining to a rate consistent with central banks’ 2 per cent inflation target. Simply put, historical and current data support the thesis that the Phillips curve is dead. To ensure it’s truly dead and buried, inflation must continue to decelerate dramatically.
James Thorne is chief market strategist at Wellington-Altus Private Wealth Inc. in Toronto.
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