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Bruno Cavalier
Chief Economist at ODDO BHF

The risk of a slide back into recession was the major question of 2019. All told: this triggered more fear than damage. For 2020, will the change of theme not prompt investors to worry about a rebound in inflation? Inflationary forces remain contained in the US, but point upwards due to geopolitical tensions (oil risk), low unemployment (wage risk), further expansion of the Fed’s balance sheet (monetary risk), trade war (tariff risk). In addition, what Donald Trump wants more than anything else is a weaker dollar. None of the above is likely to worry the Fed, however.

The week's focus

For the sixth time in seven years, US inflation will stand below the Fed’s target rate in 2019. Generally speaking, inflation expectations for the medium term are not taking off. The markets’ favourite metric, the breakeven point for 5Y5Y inflation, barely picked up since last summer, whilst in the intervening period, the probability of recession over the next 12 months has been revised sharply down (chart lhs).

In the eleventh year of expansion, we would be justified in expecting higher inflation. According to the CBO, the output gap is now positive, to the tune of 0.7% of GDP. There may still be unused resources in the labour market, but they are tending to disappear. Once this is done (at the current rate, it may take another two to three years), wage growth could then come out of the top of the zone where it is trending. Wages are on a trend growth of about 3% per year, which is not excessive (chart rhs). Moreover, the recovery in wages seen since the end of the recession has not exceeded productivity gains and unit labour costs have not spiralled. There is every reason to think that the equilibrium employment rate has moved lower, which delays the moment when labour market strains are likely to emerge. The other possible sources of inflation remain contained. The tariff increases have had little impact on end prices. Oil prices are showing some volatility (see p.2) but are not on an upward trend. Last, we find it hard to believe that the Fed’s resumption of purchases of government bonds will cause the dollar to plunge. Overall, inflation is likely to accelerate in 2020, lifting the rise in the PCE index towards the target of 2% (versus 1.4% in 2019). What would happen if the uptick were more marked? The Fed has a simple answer: nothing. After years of below-target inflation, the Fed has no problem letting it rise above the target. In short, even if inflation picks up, there is very little chance of monetary policy being tightened this year. The elections also make this unlikely. 

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