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2' Viewpoints

The Lowdown on Inflation

20/09/2018

Omair Sharif, Senior U.S. Economist for Societe Generale, was a panelist at Euromoney’s recent Inflation Conference in New York City. We asked Omair to let us in on the latest thinking about the hot topic of inflation: why we care, what causes it, its relevance to the U.S. economy and markets, and where he thinks it is headed.

Why is inflation an important topic of discussion right now ?  

It’s all about interest rates and where they are going down the road. So far, even with a pretty strong economy, the U.S. Fed has been able to keep rates historically low because inflation has been modest. If it starts to accelerate and threatens to get well above the Fed’s 2% target, then the Fed will respond by raising rates faster, and higher, than what most people currently expect. That has implications for all asset markets, so that’s why inflation is front and center right now. 

How should we look at inflation?  At what level does it become a threat to the continuing health of the U.S. economy ?

What you want is for people to expect a stable and modest pace of inflation in the future. If inflation is too cold, meaning people think prices will stay really low, or even drop (deflation), they’ll hold off on buying goods and services. That will lead to slower economic growth. If inflation is too high, or running hot, you’ll get less for your hard-earned money, and people will be worse off. A little inflation, though, is just right. It sort of greases the wheels of the economy.

How much of an impact does Fed policy really have on controlling the inflation rate and has the Fed been managing inflation effectively, in your opinion ? 

It’s easy to judge the Fed’s performance because they have an explicit goal to keep inflation at a 2% target, which they take to mean prices are stable. In that respect, they have fallen short for most of the last two decades. Frankly, it’s not necessarily the Fed’s fault. There have been so many structural changes in the economy, especially as it relates to technology, that have led to a breakdown in the way we think the inflation process works. The Fed can certainly still choke off high inflation with rate increases, but it’s less clear that easy Fed policy can boost low inflation. 

What has a greater influence on inflation, the Fed’s increasing of rates, which should have a mitigating effect, or the Government’s current fiscal stimulus like the recent tax cuts, which should spur inflation ?

Good question, and this was a big topic of discussion at the Euromoney Inflation Conference. I would say the Fed wins this one. The way the stimulus was constructed isn’t going to lead to a surge in consumer spending that will generate inflation. A lot of it was meant to spur investment. If those investments boost productivity, then they’ll actually lower inflation down the road. So, it’s tough to see how the stimulus leads to much faster inflation. 

Has the change in the U.S. administration and subsequent change in Fed leadership changed how the Fed is confronting inflation ?

The administration’s stimulus package has certainly gotten the Fed’s attention. We haven’t had a situation when an already strong economy got juiced up via stimulus since the mid-1960s. Fed officials are aware that back then, inflation accelerated sharply a couple of years later. So, they’re watchful because of the stimulus, but this isn’t the 1960s.

When we do experience a rise in inflation, what is likely to happen to the bond and equity markets ?

Bonds hate inflation, so any signs of accelerating inflation is bad news for bonds. For equities, it is a bit more mixed, as a rise in inflation could mean some firms have better pricing power, and possibly better profits. So, it could be a buying opportunity. In terms of when we’ll see faster inflation, that’s not clear. It’s tough to see a scenario when inflation really moves up to 3%-4% from the current 2% pace.

Classic economics says there’s a correlation between inflation and employment.  Why haven’t we seen higher inflation with such tight employment ?

If I had the answer to this, I’d probably win a Nobel prize! Historically, this relationship was about lower unemployment leading to higher wages, which then translated to higher inflation. It hasn’t worked in 20+ years, and economists are re-examining its usefulness in how we think about the inflation process. The reasons offered range from the rise of companies like Amazon and Walmart, who keep prices low because they care about market share, to technological improvements that give everyone a chance to shop for the best prices on their phones, to globalization, which has flooded the country with cheap goods. There’s some truth to all those reasons, and I would add the decline in bargaining power for employees to that list.

Where do you see the U.S. inflation rate in the next 6 months or year ?

The Fed’s preferred inflation measure is known as the core PCE index. It strips out volatile prices like gasoline and food and gives a better idea of the inflation trend. For that measure, I think we could see it possibly edge a little lower from its current 2% rate. The big caveat here is tariffs. If the administration moves forward with more tariffs, consumers will almost certainly be paying more, and that will show up in the data. That’s not the kind of inflation the Fed wants to see, though.

 

Unless otherwise stated, any views or opinions expressed herein are solely those of Omair Sharif and may differ from the views and opinions of others at, or other departments or divisions of, Societe Generale (“SG”) and its affiliates. No part of Omair Sharif’s compensation was, is or will be related, directly or indirectly to the specific views expressed herein. This material is provided for information purposes only and is not intended as a recommendation or an offer or solicitation for the purchase or sale of any security or financial instrument. The information contained herein has been obtained from, and is based upon, sources believed to be reliable, but SG and its affiliates make no representation as to its accuracy and completeness. The views and opinions contained herein are those of the author of this material as of the date of this material and are subject to change without notice. Neither Omair Sharif nor SG has any obligation to update, modify or otherwise notify the recipient in the event any information contained herein, including any opinion or view, changes or becomes inaccurate. To the maximum extent possible at law, SG does not accept any liability whatsoever arising from the use of the material or information contained herein.

This publication should not be construed as investment research as it has not been prepared in accordance with legal requirements designed to promote the independence of investment research. Therefore, even if it contains a research recommendation, it should be treated as a marketing communication. This publication is not subject to any prohibition on dealing ahead of the dissemination of investment research. Notwithstanding the preceding sentence SG is required to have policies in place to manage the conflicts which may arise in the production of its research, including preventing dealing ahead of investment research.

Omair Sharif Senior U.S. Economist for Societe Generale Societe Generale