Zurich’s Thomas Liebi on the spectre of inflation

The recent equity market sell-off was partially triggered by fears about accelerating wage growth and inflation, potentially followed by a more rapid normalisation of monetary policy.

Global inflation remained stubbornly low during most of last year, despite an ever tighter labour market and a shrinking output gap. In January, however, both wage growth and inflation accelerated considerably in the US, stoking fears of higher inflation, pushing up bond yields and putting pressure on equities.

The pickup in inflation was broad-based and driven by both core and non-core components. However, although wages grew at the highest rate since 2009, they have to be put into perspective with rising productivity. Real average weekly earnings were up 0.9% year-on-year in December. At the same time, output per hour worked was up 1.1% year-on-year.

As long as real wage growth is compensated by higher productivity, rising wages will not necessarily lead to higher inflation rates. Given that the US Federal Reserve has already pencilled in higher inflation rates for this year and next in its forecasts, it is unlikely to significantly lift both its inflation projection and the future rate path in the near term. Nevertheless, the Federal Open Market Committee will feel encouraged by the latest development and will continue to gradually normalise monetary policy.

While inflation is accelerating in the US, it is still far from central bank targets in many other regions, particularly in Japan and the Eurozone.

Rising expectations

Inflation expectations measures have risen, but still undershoot their historical levels in most regions. Emerging market inflation has also been subdued, allowing central banks to maintain a dovish stance. This has helped to spur growth but, with a few exceptions, has not led to a rise in EM inflation, as excess capacity persists.

While inflation data remains weak, the global economy is in a synchronised expansion, with growth above trend in most regions. This is the first time in a decade that this is happening on a sustained basis, and global excess capacity is diminishing. Judging by history, this should, over time, be reflected in higher price and wage inflation.

Arguably, we are also seeing this in survey data. The global Purchasing Managers Index input and output price components show that price pressures have risen in most regions.

Following a period of sustained inflation weakness, a key question is whether we might witness a break higher in inflation, given strong and synchronised growth, tight labour markets and liquidity injections by central banks. In our view, this is unlikely.

First, there is no evidence that wage inflation is about to accelerate sharply. Even in the US, where the labour market is running hot, the latest data shows only a modest pickup in average earnings growth. Second, credit growth is solid but stable in most regions, and there is no sign of credit-induced excess demand posing an upside risk to inflation. Third, central banks are now scaling back stimulus in anticipation of higher inflation.

In our view, this should help prevent a significant inflation overshoot.