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posted on 01 December 2016

What Would It Take For Inflation To Surge - Or Even Just Emerge?

by Gene D. Balas

As we discussed in our recent post on inflation expectations driving bond yields higher, one might naturally wonder whether the inflation expected by market participants might even transpire.

beach.storm.approaching.380x240

Some may point to a tight labor market driving wages up; others to central bank actions (especially abroad); and of course, there is the stimulus plan proposed in generalities by the new administration. But will these really spark inflation? After all, if there were an easy fix, surely Japan would have found it by now, more than two decades after its disinflationary slump began.

Inflation is determined by a host of variables, so let’s break down different drivers of inflation and cover each separately. In this article, we’ll discuss the basic inputs of materials and labor, and in future articles we’ll cover other forces that might conspire to spark inflation.

Many raw materials for infrastructure spending are produced in China

Starting with raw materials, according to the U.S. Geological Survey’s Mineral Survey, China produces more than half the world’s cement - 31 times as much as the U.S. - and is the largest cement producer. China produces half the world’s steel, and about 11 times as much as the U.S. Will it even be possible to implement a large infrastructure plan that focuses only on U.S. producers? If not, much of the demand (and inflationary pressures) will flow overseas.

Relationship between inflation and the unemployment rate has recently been tenuous

But what about all the people a stimulus plan might hire (and ignoring the very important consideration of the availability of suitably-skilled workers)? Wouldn’t a tight labor market cause wages to march higher, as employers would scramble to find talent? Economic theory suggests an inverse relationship between wages and unemployment in the well-known Phillips Curve, which suggests as unemployment falls, wages rise by some mathematically-determined amount. In some periods, the relationship appears clear, but it becomes less visible more recently, as seen in the nearby graph.

11_21_image1.png

Relationship between the unemployment rate and profit margins is also low

There might be a buffer, however, to this argument in the form of corporate profit margins; not total profits, but profit margins. A company naturally wants to maximize profits. In pure theory, a company will hire another worker or take on a new project even if the profit from that endeavor is only a penny. Obviously, it doesn’t quite work to that extreme, but companies may sacrifice margins in order to maximize total profits by increasing the volume of sales and increasing production capabilities to do so.

That company may make a smaller profit on each additional item sold when it needs to hire a new worker at a higher wage, but it might find hiring is still profitable. The same company may find its revenues are maximized at a certain price, which may mean not passing all of higher wage costs onto its customers in order to maintain volume. So, while there is theoretically some relationship to inflation from a pass-through of higher wages, it doesn’t necessarily present itself in neat mathematical formulas when it comes to the collective decisions of many thousands of employers, as seen in the nearby graph, using profits as a percentage of nominal GDP as a proxy for profit margins.

11_21_image2.png

Conclusion

Now, having walked you through different conceptual ways the unemployment rate could influence inflation and/or corporate profits, I will now burst any thought balloons you might have formed that there is a strong relationship between these variables. Statistically speaking, there isn’t. The correlations between either our proxy for corporate profit margins and the unemployment rate or inflation and the unemployment rate are very close to zero.

But this exercise is hardly in vain. Economists have been puzzling for some time why inflation hasn’t risen alongside the drop in the unemployment rate. Meanwhile, the Fed is vigilant for any signs that inflation might emerge with the labor markets at so-called full employment. Markets have been expecting the Fed to be more active with raising rates in this environment - expectations, formed from even the Fed itself - was for four rate hikes this year, at least before the year started.

So, inflation may or may not arise this year. It is unclear whether a stimulus plan will be approved by Congress. It will take time for engineers to plan projects, and then to find contractors and subcontractors. We would see quite a long lead time before inflation becomes evident. Of course, the market looks ahead many years, especially when considering bonds of a long maturity. But is the market right that a stimulus plan necessarily means significantly higher inflation, and if so, when and how much?


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The information and opinions expressed herein are obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital. Opinions expressed are current as of the date of this publication and are subject to change. Certain statements contained within are forward-looking statements including, but not limited to, predictions or indications of future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties. Indices are unmanaged, do not consider the effect of transaction costs or fees, do not represent an actual account and cannot be invested to directly. International investing entails special risk considerations, including currency fluctuations, lower liquidity, economic and political risks, and different accounting methodologies.

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