To the degree the recent wild swings inside stock market are rooted in economic fundamentals, these are the fundamentals to fear: of which the already strong economy may overheat, inflation may spike, as well as the Federal Reserve may then raise interest rates more aggressively to try to combat of which higher inflation.
The kernel of evidence of which supported those fears was a report Friday of which average hourly earnings for American workers rose 2.9 percent over the 12 months ended in January, the highest since the economic expansion began nine years ago.
This specific’s only one particular data point, as well as an erratic one at of which. yet when paired using a rock-bottom unemployment rate as well as some signs of acceleration in economic growth, This specific suggests of which overheating/inflation can be a meaningful risk for the United States economy in 2018 in a way This specific hasn’t been for a decade.
What does This specific all mean as well as how real can be the risk? To answer the question, This specific helps to start with some basics.
What can be inflation?
Inflation can be when the buying power of a currency falls over time. When inflation can be 2 percent, a basket of products of which cost $100 today might cost $102 a year via at This specific point.
yet people buy lots of different things, some prices are always rising as well as others falling, as well as the exact mix of items I buy can be different via the mix of items you buy.
of which’s why government statisticians as well as mainstream economists focus on indexes created to try to capture the full range of goods as well as services people consume, weighted by how much an average household spends on each.
Plenty of people may have their own preferred way of measuring inflation; in recent years a profusion of commentators has emphasized declines of the dollar relative to various other world currencies, or to gold, as definitive evidence. yet the advantage of broad indexes can be they approximate, if imperfectly, how much prices are changing for the range of things ordinary people buy.
can be inflation not bad or bad?
This specific’s both.
High inflation can be disastrous. In Venezuela right at This specific point, in Zimbabwe a few years ago, in Weimar Germany inside early 1920s, inflation was so extraordinarily high of which the currency essentially ceased to be a useful medium of exchange, leading to a barter economy as well as breakdown of the country’s financial system.
Even milder versions of high inflation, such as the inflation of which topped out at more than 14 percent inside United States in 1980, can be damaging. At of which level, those who have accumulated savings or fixed pensions see their purchasing power vanish over time as well as borrowing costs skyrocket (ask anyone who took out a home loan inside early 1980s what their mortgage rate was). of which dynamic can impede growth as well as create broad unhappiness. The economist Arthur Okun even invented the “misery index” inside 1960s, calculated by adding up the unemployment rate as well as inflation rate.
yet when inflation turns negative — of which might be deflation, meaning the purchasing power of a currency rises over time — This specific also can be disastrous. Debts become more onerous over time, as well as consumers as well as businesses have incentive to hoard cash rather than spend or invest This specific.
of which’s what the United States as well as various other countries experienced during the Great Depression, as well as This specific has been experienced in milder forms by Japan over much of the last 20 years as well as Europe since 2010.
So how much inflation do we want?
This specific might seem inherently bad to contain the purchasing power of a falling dollar. yet having a bit of inflation seems to grease the wheels of the economy while not distorting economic decisions too much. This specific helps cushion against deflation, as well as gives the Fed room to cut interest rates as well as stimulate the economy during a downturn, helping keep the economy on an even footing.
Over the last couple of decades, central bankers around the planet have mostly settled on 2 percent per year as the optimal level of inflation of which they aim for. This specific’s a level low enough of which the purchasing power of their currencies can be fairly stable as well as people don’t have to worry about inflation all of which much in doing business with one another, while also keeping a buffer to prevent deflationary effects via taking hold.
of which said, 2 percent can be a fairly arbitrary number, as well as some economists argue of which steady inflation at a somewhat higher level might help prevent recessions.
The important thing can be arguably less the exact level of inflation as well as more of which This specific can be fairly stable over time. This specific can be big swings of which tend to be most disruptive, favoring either debtors (inflation) or creditors (deflation), as well as generally contributing to lack of faith in a country’s financial system.
For at This specific point, though, 2 percent can be the goal.
How much inflation are we getting?
Under the inflation measure of which the Federal Reserve most focuses on, prices rose only 1.5 percent in 2017, below the target. of which’s based on the personal consumption expenditures cost index, excluding food as well as energy (the logic being of which commodity prices can swing wildly for reasons unrelated to underlying inflation trends).
of which’s not far via the 2 percent target. yet the numbers have been undershooting of which target continuously since 2012. of which undershooting has been a key rationale for the Fed’s keeping interest rates low — its aim can be to boost economic growth thereby help get inflation up to the 2 percent target.
Wait, what does inflation have to do with economic growth?
The answer can be more uncertain than you might think. A central component of the versions of which mainstream economists have used for decades can be of which the inflation rate can be shaped by the amount of “slack” or unused capacity inside economy, especially unemployment.
The intuition goes like This specific: When the unemployment rate can be high, there are lots of workers available for any employer of which wants to hire them. So employers don’t need to compete for workers by paying higher prices. yet if the unemployment rate can be low, companies have to pay more to get employees, driving up wages. Higher wages in turn mean more money coursing through the economy chasing finite goods as well as services, creating inflation.
of which basic relationship between unemployment as well as inflation can be known as the Phillips Curve. This specific did a pretty not bad job explaining inflation trends via the 1950s to the 1980s, as well as still forms the underpinnings of how many policymakers think about where inflation comes via: of which inflation can be essentially evidence of which the economy can be running too hot, producing goods or services at a level of which can be not sustainable.
This specific can be a little like revving a car. Once a car can be already at top speed, if you push the accelerator harder, you won’t go any faster, yet you may overheat the engine. Inflation, in This specific type of how the planet works, can be the evidence of overheating.
can be of which definitely how the planet works?
of which’s not at all clear.
For one thing, the Phillips Curve relationship hasn’t been working quite right inside last decade. The unemployment rate has fallen via 10 percent in late 2009 to 4.1 percent today, as well as yet wages have been rising at a modest rate, between about 2 as well as 2.5 percent, throughout of which time (at least until the January 2.9 percent gain).
Even as wage gains start to emerge, the relationship between higher wages as well as overall inflation isn’t ironclad, either. For example, the Fed’s preferred inflation measure dipped through the first eight months of 2017 despite a low unemployment rate as well as steady wage gains.
You can imagine a lot of factors of which affect inflation of which are unrelated to the domestic labor market. Perhaps in a modern, globalized world, when there can be a shortage of American workers companies are better able to outsource service work as well as import manufactured goods, rather than bid up wages.
If low unemployment spurs brand-new investment in productivity-enhancing machinery, wages could rise without broader inflation breaking out, because higher worker pay might result in higher output, not just more money chasing the same goods.
Or maybe employers have so much power inside labor market at This specific point of which they can keep wages depressed despite low unemployment, rather than get in bidding wars with one another.
The traditional overheating story might be right. yet the recent evidence can be hardly definitive.
What does This specific all have to do with the stock market?
The unemployment rate can be already low, as well as the brand-new tax cut may push economic growth even higher. Wall Street knows of which if Fed officials think inflation can be poised to exceed its 2 percent target, they will raise interest rates to try to stop of which via happening.
If the Fed — under brand-new leadership, as Jerome Powell became chairman This specific week — believes This specific can let the economy roar ahead without inflationary pressure, This specific will probably continue its recent practice of low interest rates as well as gradual rate increases, which in turn can be not bad news for stocks.
yet if the overheating/Phillips Curve narrative can be coming true, the Fed will have to raise interest rates to try to cool the economy, which might make capital more costly for businesses as well as dampen consumer spending. of which’s all bad news for stocks.
What happened Friday was of which a wage number was published of which was consistent with the overheating/Phillips Curve story of how the economy works, which can be why markets sold off.
So can be high inflation definitely a risk right at This specific point?
For the last decade, the Fed has been more focused on trying to get inflation higher rather than lower, so in some sense the possibility of finally breaking out of of which low-inflation, low-growth, low-interest-rate pattern might be welcome.
Right at This specific point, prices inside bond market suggest of which the Fed can be in a sweet spot — of which inflation will indeed hover around 2 percent inside years to come. As recently as August, inflation-protected bond prices implied of which prices might rise only 1.6 percent a year over the next several years; of which can be up to 2 percent at This specific point.
yet there are risks on both sides of of which forecast.
One month’s wage number doesn’t definitively mean of which the first step of the overheating story can be happening — low unemployment translating into higher pay for workers. as well as This specific definitely doesn’t mean of which the second step can be happening — higher wages translating into higher overall cost inflation.
Seeing how things evolve in 2018 as well as beyond will be fascinating not just for watchers of the stock market as well as the Federal Reserve, yet also for everyone who might like to see a bigger paycheck, or dreads what higher inflation might do to their savings.