Escalation Of Inflation? Doubtful

Summary

• From an investor's standpoint, it's too important to understand the forces contributing to rising rates.
• Wages are clearly one of the largest expenses businesses face. Therefore, wage inflation must be monitored closely by the Federal Reserve.
• There appears to be some slack in the labor markets keeping wage inflation in check.
• Old Fed tools have proven to be outdated and question the viability of the Phillips Curve.
• With Goldilocks alive and well, equities should continue their move to new highs, at least for a while longer.

Back in March, a fellow contributor to Seeking Alpha, Roger Salus did a very well-written article on Monetary Tightening: The Wildcard for a Wounded Economy. He discussed how the concept of full employment was deceptive and explained how unemployment rates observed in the US today no longer accurately measure the strengths of the US economy.

Here is my attempt to drill down a little further on this subject. From an investor's standpoint, it's too important to understand the forces contributing to rising rates. An escalation of the 10-year treasury yield could raise havoc in the equity markets and the economy.

As the spreads between the 2-year and 10-year treasury widens or flattens, equity markets appear to be directly affected. Currently, with the Fed raising rates, we have seen the spread narrow to 52 basis points.

Keep in mind the two mandates of the Federal Reserve are to achieve maximum employment and to do it in such a fashion it supports their second objective of keeping inflation in check.

Wages are clearly one of the largest expenses businesses face. Therefore, wage inflation must be monitored closely by the Federal Reserve. It is crucial the Federal Reserve has tools to measure at what point, unemployment reaches a level of full employment. Today, for instance, the Federal Reserve believes we are approaching the point but seems to lack confidence in that position.

Back in the early 90s, the Fed's tool of choice was the NAIRU, non-accelerating inflation rate of unemployment. This is a relatively easy concept to understand. Back in the early 90s, it seems that number was somewhere around 5.75%. An unemployment rate below 5.75% was considered the point where the labor supply was tight, wages increased, and the cost of labor was causing inflation to rise.

It was a simple Phillips Curve that they used in determining a major component of inflation. Today, this number, in and of itself, has not been effective in determining full employment. Many economists believe today that the Phillips Curve has become obsolete, but we will leave that to the historians.

NAIRU is affected by several other factors.

A variable that must be considered in making this calculation is the participation rate of the labor force. For instance, historically, 66% of our population participates in the labor force. Today, that number has been stable between 62% and 63%.

There are several items that have contributed to the lower participation rate. For instance, from a demographic standpoint, the aging population has contributed significantly to its fall. There are 74 million baby boomers exiting the labor force. Then, on the other hand, the unemployed plus discouraged workers and part-timers looking for full-time opportunities have also contributed to the fall in the labor force participation rate.

Here is what Dallas Fed Pres. Kaplan had to say about the outlook for the labor force participation rate going forward.

Kaplan noted that the US labor participation rate was around 66% in 2007, right before the onset of the Great Recession. Today, it stands at roughly 63%. So, despite recent growth, the labor force has yet to rebound to pre-crisis level.

The current unemployment rate is 4.1%, one of the lowest rates seen in many years. It's easy to conclude we must be at or very close to full employment as stated by many economists and subject to wage inflation.

On the other hand, there is clear evidence seniors are moving back into the workforce, many extending their retirement age to age 70. With efforts being made to bring jobs back to the US through corporate tax reform and fairer trade deals, I am not so sure there is not a significant slack in the labor force that could drive the unemployment rate significantly lower before it becomes inflationary. This could help to increase the labor force participation rates.

Labor productivity increases would help significantly in keeping inflation in check also.

Simply put, if the participation rate could be driven back up to near that 66% level Mr. Kaplan was referring to, we could see some time before inflation becomes a significant risk.

Why is all this important?

Most all asset classes are priced and valued based upon the yield of the 10-year treasury. If, in fact, inflation is kept in check, the Federal Reserve will not have a need to escalate interest rate hikes above 75 basis points currently planned for 2018. Rates could stabilize and the Fed's "normalization process" would be near completion.

Let's keep in mind, we desperately need sustained wage growth, that will not happen without productivity gains. Clearly, we cannot sustain a healthy economy with so many underemployed. We need a labor force that is gainfully employed. Hopefully, the new technologies will help on both these fronts.

Congress has clearly stoked the economic fires with all its fiscal stimulus, "spending like a drunken sailor". This should escalate economic growth for a couple of years. Keep in mind though, whenever you have too many dollars chasing too fewer goods you have inflation.

It's important to note with our aging population and little wage growth, consumption will find it hard to grow from its current levels.

Therefore, it is crucial we increase our exports and reverse the huge trade deficits. Which brings me to the lively topic of tariffs.

Tariffs are inflationary and can tumble economies. I believe the recent talk of a trade war is way overstated. It appears we will have a new version of NAFTA agreed upon as early as this week.

Chinese trade constitutes over half of our trade deficit and that must be corrected and not just for the US. China's trade policies have affected the entire world.

It is in no one's best interest for this to escalate into a full-fledged trade war. It is the last thing China needs with their current economic situation. Their economy is currently on thin ice and has a lot to lose. By no means do I believe an increase of tariffs on our exports to China is good for the US either.

At the same time, stealing intellectual property, currency manipulation, and dumping of products by China must end. Did you know China is considered a developing country and under WTO (World Trade Organization) gets special treatment? I think that is about to end.

I believe cooler heads will prevail as they have appeared to with NAFTA.

From an investor's standpoint, I encourage you to buy the dips as the media continues to create noise. The economy overall is on solid footing. Corporate earnings should be up 18% in the first quarter according to most estimates. Fundamentals look strong and barring any crazy geopolitical event, equities should do well. My best guess is volatility is back for a while and I'll be taking advantage of the opportunities.

On the fixed income front, I would still be very cautious. Treasury Yields are still moving up and will go higher as the Fed continues to raise rates. Keep in mind, rates abroad are about to go up also. Japan and the EU have indicated increases later this year.

Inflation will be kept in check by the Federal Reserve. I believe there is still slack in this economy regarding employment. Wage inflation should not be an issue for some time to come. I don't believe it will increase much more than the 2% the Fed has targeted.

I think Goldilocks is going to hang out a little longer "not too hot, not too cold, but just right". I'd still have your seat belt on because it's going to be bumpy.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.