The Janet Yellen Fed clearly is paying close attention to the labor markets, and she has remarked several times that she thinks the unemployment level is unacceptably high.
She sees a lot of slack in the labor markets and is particularly interested in seeing wages rise. The labor force participation rate also is key for Yellen as she has indicated that this indicator, too, must also be on the rise before tightening monetary policy.
In addition, she called the recent upticks in all of the inflation measures “noise,” which the market interpreted as a blowoff of the emerging view that inflation has become an issue. Her views on a declining participation rate imply that she sees this indicator as cyclical, which means it will turn around in a rapidly growing economy. But many economists believe what has happened to the participation rate is structural, having to do with demographics and with the rapidly growing sectors of the economy (technology and biosciences) demanding high-level skills.
Thus, if the participation rate decline truly is structural, then no amount of monetary stimulation will reverse it.
U.S. economic growth and emerging inflation
Despite Yellen’s view of slack in the labor markets, all of the subindicators are showing signs of strength. Initial unemployment claims, for example, down near 300,000 per week, are where they were in the ’07 boom.
The number of unfilled jobs now stands at 4.5 million and is rising. And the quit rate has been rising for several quarters, indicating that those with skills are confident that they can find employment elsewhere.
At the same time, nearly every inflation subindicator is rising. We all know that the official inflation rates are significantly skewed to the downside. But to label what we have recently seen as “noise” sends a signal to the markets that the Fed’s 2 percent target rate is really a floor and that the Fed will tolerate significantly higher levels of inflation. Markets, of course, quickly adjust to such perceived attitudes.
Relying on lagging indicators
Typically, the recovery portion of the business cycle starts with an increase in consumer financial health — in this case, record-high stock prices. It is followed by an increase in credit. U.S. bank lending set a record in Q1.
The recovery then includes rising prices. CPI is now 2.1 percent year over year and more than 3 percent annualized during the last three months.
Finally, wages rise when wage earners realize that they have bargaining power.
Note that rising wages come last in the chain.
Thus, by targeting wages, the Yellen Fed is targeting one of the most lagging indicators possible.
If it continues to drive by looking through the rearview mirror, it won’t see the emerging inflation issue that it would see if it were looking ahead and will end up, as usual, way behind the inflation curve.
Firing on all cylinders
Despite the minus-2.9 percent GDP print for the first quarter, much of which was weather-induced, the latest data reveal:
• A tight and tightening labor market (200,000-plus net new jobs for four months in a row, a feat not seen for the past 14 years)
• Rapidly rising new loans in the nation’s banking system, industrial production surpassing its ’08 peak
• Capacity utilization approaching 80 percent, long considered to be the ceiling without having to employ outdated technology or shuttered plants.
From the point of view of someone looking through the front windshield, not only is there no recession in sight, but also a 3.5 percent GDP growth rate might be as fast as this highly regulated economy can go without significant inflation.
So, there we have it: an economy firing on all cylinders with the Fed continuing to have the accelerator pressed to the floor. This must inevitably end with rising interest rates. Without a sea change in attitude, the Fed clearly isn’t going to initiate rate hikes, but the markets eventually will when inflationary expectations break out.
No one really knows when that will occur, and just to throw a monkey wrench into the works, the emerging currency wars might serve to keep interest rates low for a while longer.
The currency wars
Slow or no growth in the U.S., Europe and Japan, coupled with a sizable reduction in China’s growth, have led nations to look to exports for their economic growth. And they do that by weakening their currency relative to those of their trading partners.
For example, in the first quarter, we saw China sell high volumes of their currency (RMB) in the foreign exchange market (for dollars). The laws of supply and demand worked to reduce the value of the RMB by about 3 percent during that period.
Meanwhile, China, now holding a whole bunch of dollars, used them to purchase U.S. Treasury securities, which, again by the laws of supply and demand, raised the prices and lowered the yields of those Treasury securities.
Japan (Yen) has been doing this since the Abe government took control, and it is quite clear that Europe (Euro) must do this in order to jump start their morbid economic system.
The tug of war
We have a tug of war going on. Inflation is now emerging, but the addiction to money printing and a return of mercantilism (i.e., the currency wars) could prevent rates from rising in the near term.
For investors, however, the risk of holding longer-duration fixed assets is just too great, given the uncertainties.
While high-yield assets have had a great run for several years, they now appear to be overpriced and particularly vulnerable to price depreciation should market expectations of inflation suddenly emerge.
Investors needing fixed-asset investments should move to Treasury inflation-protected securities, which protects from price depreciation due to inflation’s influence on interest rates.
As inflation emerges, hard assets, such as REITs, and energy producers and associated industries will benefit. And a growing economy, even at 3.5 percent, will be a great tail wind for those investments.
Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value Advisors (UVA), Reno, NV, a Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee. Robert is available to discuss client investment needs. Call him at (775) 284-7778.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.