The front page of my WSJ this AM, above the fold, screams: “Treasury Yields Ripple Through Markets.” The 10-year yield was up for five days straight as of yesterday, approach a 52-week high at 2.609%.
The 10-year “breakeven rate,” a market-based measure of inflation expectations (it’s the difference between the 10-year rate on inflation-protected bonds (TIPS) and the 10-year Treasury yield; thus, a measure of expected inflation, 10-years out), rose sharply in recent days, and has cracked 2% for the first time since last spring.
The stock market continues to climb.
The unemployment rate remains below most measures of the “natural rate,” i.e., the rate thought to be consistent with stable inflation. FTR, we cannot measure the natural rate with any degree of precision, so I wouldn’t make much of this one.
What’s more important to that part of the discussion (low unemployment) is what I wrote about at the WaPo today: we are, in 2018, throwing considerably more fiscal stimulus at an economy with already low unemployment than has historically been the case.
How unusual is [this]? Well, looking at data back to the late 1940s, the average deficit-to-GDP ratio when unemployment was below 5 percent was close to zero. Since 1980, that same calculation yields an average deficit-to-GDP ratio of 0.5 percent. As I mentioned, the jobless rate this year may average less than 4 percent while the deficit-to-GDP ratio could be about the same, and closer to 5 percent next year. So, pretty unusual.
All of which begs the question: are we starting to overheat?
My answer is “no.” Heat does not imply overheat. True, both realized and expected rates of interest and inflation are rising, but that’s what I’d expect at this point in the recovery, and they’re still at relatively low levels. Yes, the job market is tightening, but both wages and employment rates imply it is not overly hot.
10 YEAR BREAKEVEN RATES (INFLATION EXPECTATIONS) AND 10-YEAR TREASURY YIELD: HEAT, SURE. OVERHEAT, NAH.
Moreover, especially as regards inflation, which still remains below the Fed’s 2% target—core PCE was last seen up a mere 1.5% (Nov16/Nov17). After running cold for so long, it would be a mistake for the Fed to push back on price growth any faster than they are already: their target is an average, not a ceiling. (Yes, this invokes much argumentation, as per this must-view Brookings conference on whether the Fed should rethink its 2% inflation target. I think so, and so do most of the speakers.)
As the figure shows, bond yields and the breakeven rate are climbing but their levels are within safe, historical ranges. I’m not at all discounting their growth rates, but it’s not unusual for stocks and bond yields to both be on the rise at this point in the expansion. It’s a pattern that points to positive expectations about growth, profitability, and inflation. The question is: are there clear utilization constraints in sight?
I don’t see them. Instead, I see a number of reasons why interest and inflation rates are up a bit, and I don’t think any of them are scary:
–Solid, slightly faster US growth rates, with even productivity growth up the last few quarters. That’s not a new, structural trend, btw, just the predictable outcome of slower employment growth as we close in on full employment and slightly faster GDP growth. (It is consistent with the full-emp productivity multiplier I go on about, but way too soon to call this one.)
–“Synchronized” global growth. Most economies are growing closer to their potential at this point in the global cycle, and the WTO tell us that the global output gap is now closed.
–At least some of the equity rally makes sense in the context of high realized and expected corporate profits. Re the latter, the tax cut lavished large goodies on the corporate sector, so even stagnant expected pre-tax profits should show up in the stock market as higher expected post-tax profits. (To clarify, I don’t find this “scary” from a heat perspective. I find it highly undesirable from an economic inequality perspective.)
–Tight job market but no obvious wage pressures, at least on the national scene. I’ve seen anecdotes of wage pressures in places with very low unemployment, but that’s as it should be. Anyone making a case that full employment is juicing wages and that’s juicing prices does not have the data on their side, at least not yet.
–Other measures of inflation expectations, like those computed by the Cleveland Fed, are slowly trending up but don’t yet show the same spike as the breakevens (though they’re lagged relative to the market measure).
–No obvious bubbles outside of bitcoin, and it is not “systemically connected” to credit markets, thank Keynes, Buddha, [your favorite deity here].
Sure, there’s some heat. After all, we’re in year nine of an economic expansion that started off pretty tepid. But heat ain’t overheat, and there’s a heckuva a lot of catching up to do out there, whether we’re talking macro-indicators like inflation, or most importantly from my perspective, wages and incomes of middle and low-income households.