For two years, one of our most consistent macro calls has been for a return of high inflation, and for that inflation to be structurally higher for longer.
Last week saw the release of the latest monthly U.S. inflation data. With oil back at $90 per barrel and gasoline prices rising, we got the first uptick in headline inflation in three months—but largely in line with expectations.
But as well as focusing on the effect these monthly data releases may have on the next central bank meeting, it is important to look at other major developments and their effect on economic growth and inflation.
In my previous post, we considered the potential strike by United Auto Workers (UAW) members, which, as we went to press on Friday afternoon, had gotten underway after the existing labor contract expired. Today, let’s consider the U.S. federal government shutdown that may occur in two weeks’ time on October 1.
The UAW strike is emblematic of a year of elevated labor activity that has resulted in some meaningful pay hikes. With unions demanding generous benefits as well as higher pay, companies seem willing to enhance the pay offers if it means avoiding some of the benefits that would be a more structural threat to flexibility and long-term competitiveness.
Therefore, while the immediate economic impact of a strike is to lower growth—some analysts estimate that this one could lower the U.S. GDP growth rate by around 0.2 percentage points for each week it lasts—the longer-term implication is higher inflation, because it signals a structural swing in wage rates, a meaningful component of most companies’ cost structures.
The same may be true of a government shutdown. Goldman Sachs estimates that, like the auto-sector strike, a shutdown knocks 0.2 percentage points off the GDP growth rate each week it lasts. Those losses get recouped once the politicians finally come to terms—but it’s the underlying political dysfunction that has longer-term implications for debt sustainability and, by extension, the structural inflation outlook.
Remember the U.S. debt ceiling crisis that was “resolved” with the Fiscal Responsibility Act back in June? Well, it was never “resolved.”
The Act assumed the subsequent passage of 12 appropriation bills, and while the Senate has passed those bills, some Republicans in the House of Representatives now want to spend less than what is specified in the bills (and amend them with a range of additional provisions). A divided Congress now has until October 1 to figure out a compromise, or else we will have a government shutdown.
With that dysfunction in mind, let’s take a look at the fiscal path the U.S. is on.
More than a third of outstanding U.S. sovereign debt is due to mature within three years. That amounts to a lot of refinancing at a time when the Federal Reserve is implementing quantitative tightening, the fed funds rate is 5.5% and the 10-year yield is 3.5 percentage points higher than it was three years ago.
According to the Congressional Budget Office (CBO), the weighted average interest rate on federal debt has already risen from 2.2% last year to 2.5% this year. As more of that refinancing occurs, the CBO expects that rate to hit 2.9% in 2024. That may not seem like much, but it makes a big difference when the stock of debt is as big as it is today.
In a recent note, the research firm Strategas put this in perspective by looking at the federal government’s net interest costs as a percentage of tax revenues. At the end of July, that ratio hit 14% for the first time in 25 years.
What’s interesting about that level, Strategas observes, is that it has historically been a good signal for inflection points in fiscal policy: When interest costs go above 14%, fiscal policy tightens, and when they come back below it, fiscal policy loosens. The Reagan administration responded to crossing the threshold with six consecutive years of tax hikes, for example.
Does that seem likely this time around? It is difficult to imagine.
With a presidential election year around the corner, few in Congress, on either side of the aisle, are seriously talking about the kind of spending cuts that were agreed to, for example, in the Obama-Boehner budget deal that ended the debt-ceiling standoff of 2011. The minority who are talking about spending cuts—in the current appropriations standoff, for example—are certainly not suggesting tax hikes. The one thing Republicans and Democrats seem able to agree on is the lack of any need for the fiscal discipline necessary to put the U.S. back on a sustainable path.
We believe this raises the threat of structurally higher inflation and the risk of financial repression. When government interest costs consume an unsustainably high amount of tax receipts, one solution is to cut other spending, another is to raise taxes—but an alternative pathway is to force interest rates down and allow inflation to erode the real cost of those interest payments.
In other words, don’t be surprised if the central bank’s price-stability mandate is interpreted “flexibly,” in order to contain the interest costs of ongoing loose fiscal policy. Inflating the economy to ultimately reduce government debt levels may be the only way out of this mess—not that it’s an ideal solution.
That is why some current events in politics and the economy—the auto-sector strike and government-shutdown standoff being just two examples—reinforce our view that it will be hard to get inflation back to target, and even harder to sustain the conviction it will take to do so.
In Case You Missed It
- China Consumer Price Index: +0.1% year-over-year in August
- China Producer Price Index: -3.0% year-over-year in August
- U.S. Consumer Price Index: +0.6% month-over-month, +3.7% year-over-year (core consumer price index +0.3% month-over-month, +4.3% year-over year) in August
- U.S. Retail Sales: +0.6% month-over-month in August
- U.S. Producer Price Index: +1.6% year-over-year in August
- European Central Bank Policy Meeting: The ECB raised its policy rate by 25 bps
- University of Michigan Consumer Sentiment (Preliminary): -1.8 to 67.7; 1 year inflation expectations -0.4% to 3.1% in September
What to Watch For
- Monday, September 18:
- NAHB Housing Market Index
- Tuesday, September 19:
- U.S. Building Permits
- U.S. Housing Starts
- Wednesday, September 20:
- FOMC Meeting
- Thursday, September 21:
- U.S. Existing Home Sales
- Bank of Japan Policy Meeting
- Japan Consumer Price Index
- Japan Markit Manufacturing Purchasing Managers’ Index
- Friday, September 22:
- Eurozone Manufacturing Purchasing Managers’ Index (Preliminary)
- Eurozone Services Purchasing Managers’ Index (Preliminary)