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Why the Federal Reserve may be sitting on an inflation time bomb

2017 looks eerily similar to 1965, a calm before the storm that would strip Wall Street equities of 60% of their value and slaughter bondholders

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The edifice of hyper-valued assets across the world is built on one elemental premise: that U.S. inflation is dead and, therefore, that the U.S. Federal Reserve will continue to bathe international finance with dollar liquidity.

We have been here before. The U.S. economy looked eerily similar in late 1965. The jobless rate had fallen to 4.2 per cent – exactly where it is now – without a flicker of wage pressure.

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2017 looks eerily similar to 1965, a calm before the storm

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It was the calm before the storm. Powerful forces were building below the surface. The U.S. was on the cusp of the Great Inflation. Wall Street equities lost almost 60 per cent of their value in real terms over the next decade. Bondholders were slaughtered.

The collective market bet is that this time it’s different. It is why investors are so nonchalant about a global economy leveraged to the hilt. The world debt ratio has risen from 276 per cent of GDP just before the Lehman crisis to a record 327 per cent today.

It is why the Shiller CAPE price-earnings ratio for the S&P 500 is now above the 1929 high at 31.12. It is why we have so many symptoms of excess, not least Wall Street margin debt at three times the pre-Lehman peak. The Bank for International Settlements warned in its latest report that this structure is sustainable only as long as borrowing costs remain nailed to the floor. Investors have bought into the reassuring hypothesis that inflation has been tamed by the “China effect” and the “Amazon effect.”

These twin forces of globalization and digital technology have smashed the labour movement. In academic argot, they have killed the Phillips Curve. Unemployment rates can fall safely below 4 per cent without igniting wages and setting off a fresh inflation spiral. That at least is the fond hope. Markets have been right so far. Inflationistas who long warned that the Fed’s ultra-radical policies would lead to surging prices patently misunderstood the global liquidity trap after 2008. Yet we are now nine years into the expansion. The U.S. unemployment rate has dropped to the “NAIRU” floor where trouble tends to start. The ratio of jobseekers to jobs on offer has dropped to historical lows.

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The Fed response under Janet Yellen has been glacial. So far she has been vindicated: core inflation has been falling. Yet the balance of risk is shifting. The worry is that the Fed will wait too long, wagering that it can safely drive the jobless rate even lower in the seductive circumstances of a dormant Phillips Curve, just as in 1965.

“I’m worried about the strategy; Janet Yellen has taken a decision to run the economy hot,” said Prof Athanasios Orphanides, co-author of the definitive treatise on the Great Inflation.

“The cautionary tale from 1965 is that once you see signs of inflation, you have to respond forcefully,” said Prof Orphanides, a former central banker now at MIT.

He thinks workers have been clinging to their jobs because the trauma of 2008 was so brutal, and this has distorted labour market signals. “It is fear. It is a depression effect like the 1930s. But the forces of supply and demand for jobs are going to kick in sooner or later,” he said.

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The Sixties were unusual. It was the era of “guns and butter.” The Johnson administration was ramping up the fiscal deficit, boosting spending on the Vietnam War and the Great Society welfare schemes. Yet Fed officials knew they were pushing the boundaries, and possibly playing with fire. Fed chair William McChesney Martin fretted about the zeal of the doves. When the Fed did raise rates in late 1965 the institution was attacked by the Democrats, then commanding both the White House and Congress. Martin was summoned to Texas for a dressing down by president Johnson. The Fed was captive.

This could happen again but the more immediate risk for markets is the opposite: that the Fed might suddenly feel constrained to jam on the brakes. We all know what would happen. Asset markets would crash.

The cautionary tale from 1965 is that once you see signs of inflation, you have to respond forcefully

Danny Blanchflower, a Dartmouth labour economist and former UK rate-setter, says the parallel with the Sixties is invalid. “Globalization is quite different today. The forces pushing down wages are much stronger. Firms can just up and go to Hungary or Thailand. If there was any truth to the inflation story we would see it in wages, and we don’t,” he said. The question is what happens when Chinese and East European unit labour costs catch up, as they may already have done. A global Phillips Curve will start to bite. In other words, it is Chinese inflation that we should be watching. Harvard professor Ken Rogoff says the greatest danger is what happens when “real” interest rates rise across the globe. “If you have a crisis in China that infects the whole region it could force Asia to call money home. This could shut down the global flow of savings. You could have a panic scenario,” he said.

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The sequence of events in the mid-1960s was fascinating. Inflation slid through 1964 even as the job market tightened. It fell to 1.1 per cent in January 1965. It then swung back with a vengeance and broke out of its historic range. By October 1966 it was 3.8 per cent. Wages gave no prior warning.

The Fed is just as divided today as it was then. It has etched in a rate rise in December but St Louis Fed chief James Bullard says the “startling” weakness of wage figures cries out for caution. He fears a “policy mistake.”

On the other side, the hawks say the deflationary effects of the strong dollar in 2015 and 2016 have played out. The departing Stanley Fischer says a “very basic force” – capacity constraints – will drive up prices with iron inevitability, even if it takes longer than expected. Fed officials know they cannot raise rates far without detonating a bond and equity crash: they are already caught in what the BIS calls a central bankers’ “debt trap”. Yet I also suspect that they will under-estimate the volcanic effects of their actions on the world financial system, since they remain wedded to a pre-global “closed economy” model.

In the end, the Fed may have no choice. If the bond vigilantes start to sniff inflation they will force up long-term U.S. bond yields and transmit the shock through global markets anyway. Bill Gross, the bond king from Janus, thinks it is already happening. He warns that if the yields on 10-year U.S. Treasuries punch above 2.4 per cent, the great bull market for fixed income assets is over. We are entering very treacherous waters.

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