Last year, Mack Research compiled a five-part series (part 1, 2, 3, 4, 5) on the inflation situation in the United States. We tried to create a holistic view by addressing inflation from a number of different vantage points: commodity prices, unit labor costs, velocity of money, TIPs and the Personal Consumption Expenditure price index (PCE).
We highlighted the pronounced bear market in the inflation rate as well as, and more importantly, an acceleration in the rate of decline. This extreme trend seemed to be nearing a turning point, somewhat like the “blow off” stage of an asset market, particularly if a catalyst presented itself. Barring a move to outright deflation, it’s logical to see at least a temporary rebound in the inflation rate.
The Catalyst: Donald Trump and Proposed Fiscal Expansion
With the inflation “rubber band” seemingly stretched, we have a potential catalyst capable of sparking a secular change in inflation levels, the election of Donald Trump.
It is unclear if Trump intends to follow through with statements made on the campaign trail relating to fiscal expansion or, if so, whether or not he’ll be able to gain the support needed to implement his proposals.
As an analyst, it is my job to weigh probabilities, draw reasonable estimates and compile a range of potential outcomes for a particular market or event. In analyzing Trump, let’s start by evaluating his track record as a person and business man. Trump’s fortune and predominant expertise is in real estate and development. He clearly has a penchant for large projects and properties, many of which stray into the trophy property category (more on ego below). For example, Trump International Hotel and Tower in Chicago and New York’s Trump Tower are irreplaceable world-class properties.
He works with the world’s largest developers and engineering firms to design, build and operate many of his assets. He has repeatedly employed and partnered with firms like Tutor Perini, Tecnoglass and Australia’s LendLease.
Does the passion to build drive him, or is it simply ego? Real estate development requires capital, planning, time and great patience. These ventures can be lucrative, but it is unlikely that he would have built his current portfolio of real estate assets without a passion for the process. With that said, ego also plays a part. What previous U.S. president didn’t have a large ego? Leading an entire country requires a certain bold personality profile. Now, given Trump’s background in real estate development, it seems logical that infrastructure projects will be of great interest to him.
Details of Trump’s proposed one trillion dollar infrastructure plan aren’t clear. However, it will surely address large projects and be a driver of employment for both blue and white collar workers. Regardless of any infrastructure bill’s final form, it will require raw materials, equipment and the involvement of many smaller subcontractors. This means big-ticket government contracts will flow through to small businesses. Although the Fed’s asset purchasing programs were widely considered to be helpful, this new fiscal stimulus should prove to be substantially more beneficial to small businesses and the broad economy.
Recent Fiscal Expansion
Even before Trump’s election, our nation was potentially starting on a trend toward fiscal expansion as our aging infrastructure and military assets became increasingly problematic and noticeable. In December 2015, Obama signed a 5-year, $305 billion highway bill in addition to signing a massive $1 trillion bill to modernize the U.S. nuclear arsenal last spring. The latter is expected to be an ongoing project through 2030 and will address intercontinental ballistic missiles (ICBMs), upgraded ballistic missile submarine fleet, strategic bombers, approximately 180 tactical nuclear weapons at bomber bases across five European countries and their supporting infrastructure.
With $1.1tn in the pipeline and another $1tn infrastructure proposition, fiscal expansion is off to a decent start.
Another budding trend can be found in domestic wage pressure, which began surfacing within the past 18 months. Unit labor costs, a strong indicator of inflation, seem to be quite stable and the annual rate of change nears the highest levels seen since the early 1980s.
Also, the Fed’s November Beige Book mentioned some interesting observations which suggest rising inflation: “As in the past four Beige Books, wage growth was characterized generally as modest, on balance, by district contacts. The St. Louis, Minneapolis, and San Francisco Districts all reported moderate wage growth.” The remaining districts showed modest growth with “staffing services [reporting] rising wages or difficulty filling positions without wage increases in a majority of the Districts”. Decoding “Fed speak” isn’t always easy, but “moderate” is stronger than “modest”. Ultimately, wage growth signals growing inflation, something the Fed monitors very closely.
Velocity of Money
I have kept the velocity of money concept in the back of mind since the Fed unleashed quantitative easing (QE) in December of 2008. This key component to inflation levels remained subdued, yet a number of people incorrectly called for inflation (or hyper inflation) over the past eight years. A number of those people also doubled down on their predictions and incorrectly called for the immediate demise of the U.S. dollar and a crash in Treasury bonds. These people simply looked at the large QE levels and nothing else; they simply focused on “the money printing” and tried to fit the circumstances to their theories by ignoring the flow and actual influence of the Fed’s purchasing activities.
Instead, the velocity of money and inflation continued to decline and the dollar rallied strongly over the last eight years. However, now that we have a president who will most likely push the country toward a more genuine (and traditional) economic recovery, rather than the pocketed recovery experienced over the past several years, the velocity of money may pick up pace. Should that occur, inflation to some degree will follow.
A number of other potential developments may impact the inflation rate going forward. Although it is only campaign talk so far, Trump seems genuinely interested in lowering the corporate tax rate, encouraging the repatriation of offshore corporate tax dollars and rolling back regulation. Although none may come to fruition, it’s worth thinking about the potential economic impact of each.
Given everything outlined above, where does this leave us? We do see inflation picking up, but it might move in fits and starts. Many of the factors addressed here will take months or years to plan and gain approval. Even upon implementation, any impact will also need to work itself through the economy. So, a higher inflation rate seems probable, but it may take several years to surface. The combination of a stretched “rubber band”, changing fundamentals and a major catalyst sounds like the best setup for a secular change that one could ask for.
Original Post: Why a Higher Inflation Rate May be Coming