Geo-Graphics

Wage growth is “not a threat to inflation,” Fed Chair Janet Yellen said on June 18.  “[With] our 2 percent inflation objective, we could see wages growing at a more rapid rate” before having to worry. “When unemployment goes into the five range, that is going to below the natural rate,” St. Louis Fed President James Bullard said on July 9.  “I think we are going to overshoot here on inflation.” Who is right? In today’s Geo-Graphic, we look at the relationship between wage growth and inflation over the last twenty years.  Perhaps surprisingly, we find virtually none (an R-Squared of 0.03).  Wage growth has routinely exceeded so-called core inflation (consumer goods inflation excluding energy and food) by large amounts without the latter picking up.  One explanation for this phenomenon may be the growth of imports as a percentage of GDP, from 9% in 1994 to 16% today, which acts to keep tradeables prices down.  This supports Yellen’s position. This does not mean, however, that wage growth should not concern the Fed.  On the contrary, as we can see from the figure on the left, unusually high wage growth—above 4%—preceded the last two recessions, in 2001 and 2007.  The explanation may lie in the fact that high wage growth induces people to assume more debt that they would otherwise. Rapid wage growth was associated with rising debt service burdens during both periods, as shown in the figure on the right.  Increasing debt service payments tend to crowd out other forms of consumer spending, and make households more vulnerable if expected wage increases fail to materialize. Annualized wage growth at present is still moderate, running at about 2.3%.  But it is clearly on the rise.  The household debt service ratio, however, is at its lowest level since the series began in 1980, and household debt is less than it was in Q1 2008—though it has started moving up again. In short, the monetary history of the past twenty years suggests that wage growth at current or moderately higher levels is unlikely to cause a significant rise in consumer price inflation.  Yet a continued trending up in wage growth would likely presage a rise in household leverage, which is a credible indicator of economic instability ahead.  But at the current low leverage levels, far ahead. The Economist: Waiting for Inflation Wall Street Journal: America Inc. Wakes Up to Wage Inflation VoxEU: The Impact of Low-Income Economies on U.S. Inflation Financial Times: Fed Bond Buying Set to End in October   Follow Benn on Twitter: @BennSteil Follow Geo-Graphics on Twitter: @CFR_GeoGraphics Read about Benn’s latest award-winning book, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order, which the Financial Times has called “a triumph of economic and diplomatic history.”

The FT’s Ed Luce recently took on the “confused signals” being sent by U.S. stock and bond prices moving in sync (upward). Which is it, he asks?  Are economic prospects good, as stock prices suggest, or bleak, as bond prices suggest? Both and neither, he offers.  High-end retailers like LMVH and Tiffany are doing great, he says, while low-end ones like Walmart and Sears are languishing.  The net effect, he concludes, is stock prices buoyed by high-end earnings optimism and bond prices supported by a hollowing out of the American middle class.  Growing inequality explains the apparent conundrum. Given the current fascination with all things Piketty, this makes a charming and topical story.  But it is also almost certainly wrong. The straight average of U.S. company stock prices in the S&P Global Luxury index is actually down 1% this year; market-cap weighted, it’s up only 3.9%.  This compares with a 6.1% rise in the S&P overall.  As for Luce’s example of Tiffany (LMVH is foreign), its stock price has lagged mid-range retailer Macy’s.  In short, there is no discernable Piketty effect in U.S. stock prices. As for bond prices, China’s central bank holds the key. After more than three years of steady appreciation, the RMB has declined over 3% this year – erasing the past year’s rise.  Driven by the Chinese government’s desire to re-juice failing economic growth, RMB depreciation has naturally been accompanied by an increase in China’s foreign exchange reserves. China usually allocates about 40 percent of its foreign exchange reserves to Treasuries; so far this year, however, its official holdings of Treasuries have actually declined.  What explains this?  Given that China comes under pressure from the U.S. Treasury and Congress whenever it appears to be pushing down its currency, China is almost certainly disguising its Treasury purchases by holding them in Belgium. As shown in the graphic above, “Belgium” accumulated abnormal amounts of Treasuries during the first quarter of the year; Brussels-based clearinghouse Euroclear has acknowledged that it is likely responsible for the increase.  China’s actions would help explain why Belgium, a country whose GDP is slightly smaller than that of New Jersey's, has become the world’s third largest holder of Treasuries, after only China and Japan. China and “Belgium” bought a massive combined $59 billion in Treasuries in January, a month in which the supply of Treasuries actually shrank by $42 billion.  This would almost surely explain a large part of the decline in Treasury yields that month from 3.03% to 2.64% In short, the “confused signals” in U.S. asset prices would appear to be driven by China’s efforts to push down the RMB, and not by Pikettification of the U.S. economy. Financial Times: Look to China for Reasons Behind Strong Demand for Treasuries New York Fed: Responses to Survey of Primary Dealers Treasury: Major Foreign Holders of Treasury Securities Wall Street Journal: China Is in No Rush to Halt Yuan’s Fall   Follow Benn on Twitter: @BennSteil Follow Geo-Graphics on Twitter: @CFR_GeoGraphics Read about Benn’s latest award-winning book, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order, which the Financial Times has called “a triumph of economic and diplomatic history.”

ECB President Mario Draghi was able to stabilize Eurozone nominal lending rates, which had been climbing dangerously in the periphery countries, with his famous do “whatever it takes” speech in July 2012.  Real (inflation-adjusted) lending rates for nonfinancial businesses, however, have risen steadily since then; in Spain, they are back up to their 2009 euro-era peak, as the right-hand figure in today’s Geo-Graphic shows. Draghi recently characterized deflation, or rather “internal devaluation,” in the crisis-hit periphery countries as “crucial adjustments vis-à-vis other euro area countries” – adjustments which “have to take place irrespective of changes in the external value of the euro,” which have been substantial (upward) over the past two years.  In the same speech he said that low private lending levels in such countries were unsurprising because of “weak credit demand,” which “in the early stages of an economic recovery is not unusual.” He acknowledged, however, that “targeted measures” could be necessary “to help alleviate credit constraints” if such constraints “impair the effects of our intended monetary stance.” We would suggest that he’s got things backwards.  With inflation having fallen to 0.5% in May, it is the monetary stance itself that is constraining credit demand by pushing down inflation expectations and pushing up the real cost of credit. Draghi should forget about “targeted measures,” and instead take broad, bold action to boost inflation expectations and tear down the wall of credit costs holding back the recovery. Wall Street Journal: Eurozone Inflation Slows, Jobless Rate Falls Financial Times: Eurozone Inflation Falls to 0.5% Economist: Draghi Spells It Out Bloomberg: Euro Inflation Slowing More Than Forecast Pressures ECB   Follow Benn on Twitter: @BennSteil Follow Geo-Graphics on Twitter: @CFR_GeoGraphics Read about Benn’s latest award-winning book, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order, which the Financial Times has called “a triumph of economic and diplomatic history.”