It was Ronald Reagan who warned against inflation in 1984 by describing it creeping “like a thief in the night to rob our savings, rob our earnings, and take the bread off our tables.” It is ironic then that President-elect Donald Trump, who borrowed his forebear’s campaign slogan “Make America Great Again” to win the White House last month, is likely to be very inflationary indeed.
Inflation, along with unemployment, is part of the dual mandate which guides the Federal Reserve when it sets monetary policy.
Joblessness in the States is at 4.6 per cent (the lowest level since 2007), and although core inflation remains below the Fed’s 2 per cent target, it reached 1.7 per cent in November. For this reason, Fed fund futures predict with almost total certainty that the central bank will announce that it is increasing interest rates by 0.25 percentage points this week.
This would be only the second interest rate rise for a decade, and would signal that the central bank is finally on the path to “normalising” monetary policy.
Markets have currently priced in between one and two further rate hikes in 2017, while the Fed’s “dot plot”, which indicates how Federal Open Markets Committee (FOMC) members think interest rates will rise in the future, suggests there will be two. However, if Trump delivers a reflationary economic programme on the scale he has suggested – $5.7 trillion in tax cuts, a $1 trillion infrastructure splurge and a roll-back of regulation such as the Dodd Frank Act on financial intermediation – the Fed may be forced to tighten monetary policy more quickly to keep prices stable.
As Reagan implied, rising prices are no good thing without the economic growth to push up wages alongside them. Since the election, investors have appeared confident that Trump’s economic programme will indeed grow the US economy more quickly. Wall Street’s main indices – the S&P 500, the Dow Jones Industrial Average, the Nasdaq composite and Russell 2000 – have rocketed to record highs since last month’s election, and the yield on 10-year Treasury bonds rose above 2.5 per cent yesterday for the first time since 2014.
Not everyone is convinced of Trump’s policies. “While higher growth is a possibility, our view is that fiscal expansion and protective trade policy when the economy is operating at full capacity makes higher inflation almost a certainty,” said Pimco’s Mihir Worah and Geraldine Sundstrom last month. But if inflation bites, the Fed might be forced to raise rates without growth.
There are a host of inflation-stoking risks, which, if realised, could cause prices to rise much quicker than expected. First, Trump could yet unravel the North American Free Trade Agreement with Mexico, and deliver on his threat to slap higher tariffs on China. According to the US International Trade Commission, China pays 3 per cent in duty, and Trump has talked about elevating this to 45 per cent in a show of aggression which could spark a trade war. China exported nearly $500bn in goods to the US last year. Consumers may end up paying more if they have to buy locally. Second, oil prices have been increasing, which will push up prices at the pumps and costs in many other sectors of the economy.
An aggressive anti-immigration policy could also be a problem, as it could bring about a supply-side labour shortage. This could even be exacerbated by any increases to infrastructure spending. Given that unemployment is already low – and the number of unfilled job positions remained unchanged at 5.5m between September and October, according to the Bureau of Labour Statistics – it may prove difficult to recruit construction workers for infrastructure projects, driving up wages in the industry. “If unemployment was 7.6 per cent, not 4.6 per cent, the infrastructure spending programme would make a lot more sense,” says David Lafferty, chief market strategist at Natixis.
What happens if the Fed has to increase interest rates quicker than is currently expected? Nominal US bondholders would see their returns eroded. Treasury inflation protected securities would provide inoculation – Pimco has described them as a “risk-free asset” in a time of rising prices. But any interest rate rise would cause the already overvalued greenback to strengthen further, weighing on emerging market (EM) governments and corporates which have borrowed in dollars by driving up the costs of servicing their debts.
However, the outlook for EMs today is better than it was in the late nineties – when the value of local currencies plummeted – because a much greater proportion of outstanding debt is in local currency. “I believe many of these currencies have already fallen quite substantially this year, pricing in the expected rise of the US currency,” wrote Edward Bonham Carter, vice chairman at Jupiter Asset Management.
Many forecasters had projected four rate hikes in 2016, but there has been none since last December thanks to worries about a depreciating Chinese currency, fears of a US recession earlier in the year and mixed economic data since. The Fed’s “dot plot” may provide an indication – September’s dot plot implied two rate increases next year. If the number of projected hikes goes up when new projections are published this week, it would suggest that the Fed is concerned that Trump’s fiscal policy will stoke inflation beyond what it expected in September. If it goes down, it signals that the Fed is perhaps sceptical about Trump’s impact on inflation, potentially because of a dearth of shovel-ready projects.
Many analysts expect a gradual path to normalisation, avoiding more hawkish signals which may later disappoint investors, as has been the case this year. Rabobank said that the number of hikes the Fed will project in its dot plot will fall to one for 2017. “The implementation lag of infrastructure spending can be considerable,” they wrote. “Second, the positive impact of the fiscal impulse may be mitigated by the negative fall-out from Trump’s trade policies.”
Investors were quick to decide that Trump equals growth. But not everyone is certain he has the policies to deliver it.