No re-run of that 70s show

Chart of the week

The bond market is already fretting about the U.S. economy overheating. However, we continue to think that the looming spike in inflation rates will be transitory.

Any worries that the U.S. labor market might have lost momentum in February were proven wrong, thanks to the blowout number which was released in early March. Despite fears of a negative weather impact, the U.S. economy is humming along. Rapid progress in vaccinations against the coronavirus is lifting spirits and making consumers more willing to spend again. Into the upswing, the administration in Washington keeps pressing the pedal to the metal with an additional round of stimulus checks.

However, not everyone seems pleased. The bond market has started to worry about an overheating of the economy. That is what you would expect to happen, when adding an extra fiscal boost to an already nascent recovery. Or, as Wall Street veteran Ed Yardeni recently put it: "[M]ore rounds of government stimulus programs this year are likely to cause a boom that overheats the post-pandemic economy."[1] U.S. Federal-Reserve (Fed) Chairman Powell himself has made several references to the bad experience of inflation spiraling out-of-control, as it was the case in the 1970s.[2]

However, our Chart of the Week suggests it would still be a long way to get there. In a Phillips-curve-based framework, we look at the relationship between the unemployment rate and inflation, as measured by the core personal consumption expenditures price index (PCE), the Fed's preferred measure. A repeat of 1970s style inflation rates would require a shift upward in the Phillips curve, in addition to a steepening.

Christian Scherrmann, U.S. economist at DWS, expects a spike in inflation rates in the coming months. A lot of the higher numbers, which in some instances could easily surpass 3%, can be explained by base effects, such as oil prices this year being compared with much lower quotes from 2020. In our view, the increase in inflation numbers is likely to be of transitory nature. We would expect inflation rates to come down again later this year. Figuring out whether the Phillips curve might really have shifted upward and become steeper will not be easy to tell, until employment has fully recovered. Maybe, however, 1994 offers a better analogy than the 1970s. If so, the Fed might still find itself in an uncomfortable position. Back then, markets were surprised by the momentum of the recovery, and concluded that the central bank ran the risk of falling behind the curve.

20210312_CotW_U.S. Phillips Curve_CHART_EN_72DPI.png

* U-3 U.S. unemployment rate seasonally adjusted
Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 3/9/21

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