Goldilocks - will the porridge ever overheat?
Cyclical inflation rising
We're currently in a Goldilocks environment - not too hot, not too cold. How long can this last? Structural forces are depressing inflation but cyclical pressures are intensifying. Even if the microwave is less powerful than before, if you keep zapping the porridge for long enough, surely it will eventually overheat?
There was a lot of excitement in the office this* morning… we had the first sighting of snow in central London!
My first thought was cynical… when will the trains be cancelled?
My second thought was more practical… should I order some extra items in my food delivery this weekend? Stock up on essentials just in case snow and ice disrupt those precious delivery slots?
Perhaps I could stock up on porridge. I have fond memories of “Ready Brek” warming me up on the way to school in the snow.
The other things we get at this time of year – besides snow, porridge and presents – are “Year Ahead” outlooks. The general consensus of the investment community is of Goldilocks – everything is “just right”. This is viewed as being great for risky assets. Not too hot to generate inflation and tighter monetary policy. Not too slow to push up unemployment and bad debts.
The Economics team agrees. But how long can this benign environment last?
I accept that structural forces are suppressing inflation. I’ve previously written about the disinflationary impact of technological innovation, slower population growth and second-round effects from the collapse in oil prices.
Nevertheless, something has changed in recent months. Traditional lead indicators of inflation – surveys of firms’ recruitment difficulties and manufacturing capacity utilization rates – have all shot up again.
Structural forces are – by definition – slow moving. So its doubtful they can offset this jump in cyclical pressures.
To use an analogy. Suppose we’re cooking porridge in a microwave. Structural forces might be akin to replacing the old microwave with a new lower powered one. For a given amount of heating time, the porridge will therefore be cooler than before. But if you zap the porridge long enough, laws of nature mean it will eventually overheat.
This analysis is supported by a recent San Francisco Fed paper.
They split inflation into ‘cyclical’ (42%) and ‘non-cyclical’ (58%) components, based on their historical relationship with unemployment.
They show that US cyclical inflation has recovered back to traditional 'late-cycle' highs. But ‘non-cyclical’ inflation is low (which they attribute to lower healthcare costs following Obamacare).
If we’re right that cyclical drivers of inflation have intensified, inflation should continue to rise from its current low base. The porridge might be ‘just right’ right now, but the good times can’t last forever, and the porridge might begin to overheat soon.
* At the time of writing... Thursday 30 November.