Inflation is rising, but fear is exaggerated

Recently, the risk of deflation has disappeared. Inflation returned and recently led to fears of more currency depreciation. The danger of a trade war between the United States (US) and China does not help either: protectionism usually means, among other things, upward pressure on inflation.

Turbulence in the markets
That fear was the reason for the recent turbulence the stock markets. The reasoning is simple: higher inflation usually means a greater chance of rate hikes by the Fed. Stocks don't like tighter monetary policy. So will the inflation soup really be eaten that hot this year?

There is a strong case for inflation (especially in the US) to rise this year. First of all, there is the fact that economic growth and inflation go hand in hand. Since the American economy is growing well and given that growth is based on several pillars (such as domestic consumption), rising prices are completely normal.

Rising wages
Second, we see inflationary pressures emerging as wages rise faster, which is to be expected with a tight labor market. The fact that the US is tightening requires no explanation, given the number of new jobs per month and the decline in unemployment. The key question is whether the unemployment market is tight.

The way to answer that question is to compare unemployment with the NAIRU (the unemployment rate in an economy where there is neither upward nor downward pressure on prices). If the unemployment is higher than the NAIRU percentage, then downward pressure on prices can be expected. If unemployment is lower than the NAIRU percentage, upward pressure on inflation can be expected.

The most recent estimate for the US NAIRU rate is 4,7%. Unemployment was 4,1% in January. Even if we take into account the uncertainty about the estimate of the percentage and the fact that the labor market has changed (less power for workers in wage negotiations), we can say that the labor market is more likely to be tight than not. This means that upward rather than downward pressure on inflation is to be expected.

What do governments spend?
What is also important for the inflation outlook is whether governments will spend more or less. Higher government consumption and more investments increase demand and can boost prices. With the major infrastructure projects in the US and the significant tax cuts, it would not be illogical to expect some upward pressure on US inflation from that angle as well.

The value of the dollar
Finally, there is the value of the dollar. Research shows that when the dollar weakens by 10% (against a basket of currencies of countries with which the US trades heavily), inflation rises by 1 to 2 percentage points after 0,4 or 0,7 years. The so-called 'trade weighted dollar' has fallen in value by about 2017% since the end of 10. This could also push up US inflation slightly in the coming months and quarters. 

In my view, we should therefore take into account that American inflation will be slightly higher in the course of this year than previously thought. However, whether that will be enough for the Fed to raise interest rates increase faster, I question.

Ignore increase
Remember that inflation can still rise without exceeding the Fed's target rate. In addition, it would not surprise me if the bank partly ignores a possible increase. The argument for this is, for example, that this extra economic growth comes from Trump's policy and that this will be temporary.   

In my view, all this will not prevent the Fed from raising rates again in June. However, whether the bank will subsequently raise the interest rate twice more seems to me to be a somewhat exaggerated fear. With the return of inflation (fear), volatility and turbulence in the stock market are back. However, that is not the same as stock prices now inevitably entering a downward phase.