Inflation Won’t Cause Problems If The Increase Is Moderate

How Much Will Inflation Pick Up

We’ve discussed inflation in previous articles. I think it will increase because the M2 money velocity is up, the NY Fed underlying inflation index is up, and the ISM manufacturing index is up. There has also been a further decline in the unemployment rate which should lead to inflation eventually. Although it doesn’t affect core inflation, oil has also been rallying as it’s now at the $57 handle. It’s somewhat surprising to see oil fall with the dollar index and rally with it. That shows how the currency impact is only one aspect of the price. The chart below shows Morgan Stanley’s prediction for core PCE. The core PCE is less volatile than the CPI, so moves less than 1% are considered big. As you can see, Morgan Stanley is predicting inflation to increase to about 1.7% next year. That will likely push headline CPI to above 2%. If the growth in inflation only goes up that much, there won’t be anything to worry about. My fear is core PCE getting above the 2015 peak.

Part of the fear of inflation is that the Fed will get too hawkish causing the yield curve to invert and thwart lending growth. JP Morgan expects 4 rate hikes in 2018. I think that would push the economy close to a recession. It’s not being priced into the market now, so that change would have big effects on the markets. I have been saying 2 rate hikes is the most likely 2018 policy. If you just look at the core PCE chart, you’d expect the Fed to raise rates more in 2018 than in 2017 because inflation will be higher. However, the Fed is also doing the unwind. Even though no one seems to be concerned about it anymore, I still think there is some uncertainty surrounding the market’s reaction to the unwind. The problem with expectations is that some bears talked about a crash when the unwind started. Now that nothing is happening, they look foolish. If you had the more nuanced stance that the entire situation is unknown, then you can continue that position without having egg on your face.

The Yield Curve Reigns Supreme… Or Does It?

There has been a correlation between the inflation rate and the spread between the 10 year bond yield and the 2 year bond yield. I don’t think this will continue. I expect the yield curve to flatten next year while inflation increases. Even if inflation doesn’t go up, I expect the yield curve to flatten. Yields can increase while flattening. That’s not some sort of impossibility.

It’s funny to see how the bears and the bulls interpret the yield curve. Because the yield curve has been normal for the past few years, the bears have found themselves fighting it. The bears have said a recession can happen without an inversion because interest rates are too low. The chart below shows another argument which adds to that point. As you can see, there were 6 recessions without an inversion over 50 years ago. You can see this chart is old because the data ends before 2015. It shows that this logic has been wrong for over 2 years. With the yield curve being correct for over 50 years, I’m not about to say it’s wrong and claim a recession is coming especially when the economy has been doing so well with GDP growing at an annualized clip of 3% in Q3.

The chart below is a model of what the yield curve should look like. The model is 4% minus the average hourly earnings growth. The model is the white line and the yield curve is the yellow line. As you can see, the model implies the yield curve is too flat. I don’t necessarily think this is a great model because there’s more to the business cycle than hourly earnings growth. I wouldn’t ignore the yield curve just because of this indicator. It would be interesting to see the yield curve invert while there is such solid growth like we have now.

Some Bad News

Even though I often discuss how good the economy is doing, there will always be bad spots. At any time, there will be charts which indicate a recession is coming. Once you recognize this, it will help you avoid being tricked by a few fancy charts. That being said, some of these negative metrics are useful if the data isn’t manipulated. The chart below is one negative metric which is important. It shows the net percentage of banks tightening standards for auto loans and the percent tightening for consumer loans excluding credit cards and auto loans. As you can see, many banks are tightening standards for auto loans. This might be part of the reason why sales have rolled over excluding the two month bump up in sales because of the hurricanes.

The tightness for loans excluding credit cards and autos looks a little better as the line is hovering around zero. Given the strength in the labor market and the fact that credit conditions are the loosest in years, you wouldn’t expect much tightness for consumer loans. There is also an increase in credit card defaults, but that’s off a very low base. I continue to believe that the indicators live and die with the labor market. It’s possible these could indicate future weakness in the jobs market, but they’ve been waving a yellow flag for about 18 months, while the unemployment rate continues to drop.

Conclusion

We looked at various ways of analyzing the yield curve to get a feel for where the economy is headed. The lending standards for consumer loans is another indicator which tells us a lot about the economy. Clearly, we’ve seen the weakness in auto sales, which has occurred for much of 2017, can’t cause a recession on its own. We’d need to see rising unemployment and tightening lending standards for all loans by more than just a net of 5% to have a reasonable fear of a recession.

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