Inflationary fears contribute to renewed risk aversion on US markets

Macro Highlights - 12/02/2018

In short
  • The rebound in volatility on equity markets was partly due to increased concerns with regard to inflation prospects following the acceleration in US wage growth in January
  • From an economic viewpoint, nominal wages are likely to accelerate in 2018, but their inertia in real terms could weigh on consumption and reduce the risk of overheating
  • However, while the US output gap is positive and nominal growth should accelerate, any increase in investors’ inflation expectations could favour greater volatility

The main event of the week was without a doubt the abrupt rise in investor risk aversion, characterised by a sharp increase in volatility and a drop in equity indices, particularly in the US. Thus, the VIX index, measuring the implied volatility of the S&P 500, which was at 17.3 at the close on Friday 2 February, hit 37.3, its highest level since August 2015, closing at a still high level of 29.1 on Friday 9 February. The S&P 500 shed 5.6% between 2 and 9 February.

One of the catalysts behind this renewed wariness was heightened concern with regard to the inflation outlook in the US following the publication of the employment report on 2 February that showed an acceleration in the y-o-y increase in hourly wages from 2.7% to 2.9% in January (see our Weekly of 5 February 2018). In the wake of this publication, inflation expectations over 10 years increased from 2.09% on 29 January to 2.14% on 2 February (their highest level since September 2014), contributing to the rise in 10-year Treasury yields from 2.66% to 2.84% over the same period, their highest level since January 2014, thus fuelling investor concerns.

From a macroeconomic viewpoint, the acceleration in hourly earnings in the US is not a surprise given the momentum on the job market over the past few quarters. There has been full employment since end-2016 according to the Congressional Budget Office, which estimates the natural rate of unemployment (NAIRU) at 4.7%[1], while the current unemployment rate is 4.1%, well below its lowest points in 2006-2007. Underemployment – which includes discouraged and long-term job seekers and part-time workers for economic reasons – also fell sharply, from 9.4% in January 2017 to 8.2% in January 2018, thus returning to pre-crisis levels. Lastly, the surveys indicate growing mismatch between employee qualifications and the needs of the labour market, as well as an increasing percentage of companies that are planning to raise salaries (see left-hand chart, p. 3). Moreover, wage growth had already reached similar levels, notably in July 2016, at 2.8%, and in September 2017, at 2.9%, although this was later revised downward.

Certain specific factors can explain this slightly stronger-than-expected wage growth. The minimum wage was raised in 18 US states, with increases in hourly earnings ranging from USD0.35 in Michigan to USD1.00 in Maine. In addition, following the adoption of the new tax measures, some large US companies also announced salary increases and bonuses for their employees in January. For the time being, these two factors suggest more of a readjustment in y-o-y wage growth than a stronger lasting trend.

Other data also tends to confirm that, for the time being, there are no signs of overheating of wages. A comparative perspective showing different wage measurements shows us that the reality is mitigated (see right-hand table, p. 3). While the Employment Cost Index accelerated throughout 2017, the Atlanta Fed’s Wage Growth Tracker weakened. Moreover, the Beige Book, the report on the economic conditions of local Federal Reserve districts, indicates that, in most regions, wages accelerated at a modest rate in January. Overall, the increase in wages observed over the past several quarters thus appears to be gradual and in line with a tight labour market.

During the next few quarters, wage growth should continue to increase under the impetus of the job market. This acceleration could be moderate, however. We continue to expect that, in the short term, the increase in nominal salaries will have a limited macroeconomic impact, as growth in real wages should remain stable. Hence, the lacklustre household spending that would result from this would limit the pricing power of companies[2], curbing their will to raise wages significantly and lowering the risk of a sharp rise in inflation.

As a result, although we continue to anticipate an acceleration in wages in 2018, we do not expect a cycle of strong acceleration in inflation. A risk for this scenario would nevertheless be, in our view, that the oil price stabilises at the levels observed in January. The rise in inflation could then be faster than expected. But this is not our main scenario, as we expect a slight slowdown in world growth in H2, due to the deceleration of Chinese growth, as well as a rebound in the dollar over the same period, which could weigh on the oil price.

Analysis and implications

  • The momentum of the US labour market is supporting the acceleration in wages in the US.
  • This acceleration is nevertheless likely to remain limited in the upcoming quarters, given the weakness of productivity, and is unlikely to result in a strong acceleration in inflation due to lacklustre household consumption.
  • However, in the context of a positive output gap in the US and with the tax measures leading to an increase in nominal growth, investors could continue to react strongly to any information relating to the risk of an acceleration in inflation. Thus, inflation expectations could push long-term yields upwards, which could result in new episodes of volatility on financial markets.
  • In this context, the next data publications, such as the CPI on 14 February, are likely to be under scrutiny. Likewise, communication by the Fed will be a determining factor in anchoring inflation expectations. The publication of the minutes of the FOMC on 21 February and the Semi-annual Monetary Policy Report to the Congress by the new Fed Chairman, Jerome Powell, on 28 February, could thus also be key.

Lisa Turk - Economist, the United States
Sophie Casanova - Economist, Central banks

[1] Federal Reserve members estimate the NAIRU at 4.6%

[2] The president of the Dallas Fed stated on 7 February: “I am less convinced that this [wage pressure] will necessarily translate into higher prices because businesses have much less pricing power”.