Inflation, Schminflation; the 10-year is a steal; Fed on hold till 2011

Warning--long post. Bottomline: inflation is headed down for the next 12-18 months at least. The Fed won't raise until 2011, possibly 2012, and that too only if the sanguine economic outcome obtains. The 10-year US treasury is a screaming buy. You can play it through IEF, TLT, options on them.

No sooner have the stock markets rallied, inflation-hawks, hyperinflationistas, so-called bond vigilantes have come out of their foxholes in full force. The long end of the yield curve has sold sharply, the 10-year yield up from its low of 2.07% earlier this year to a high of 3.7% a few days back. The usual arguments-- "we are printing money up the wazoo," "US federal debt burden is unsustainable," Chinese don't want to hold Treasuries,"--are back in full force. Of course, no one really bothers to explain how we are actually going to get to high inflation from the current deflationary environment. Printing money, running deficits are axiomatically supposed to create inflation, if not today, definitely someday in the indefinite future. Never mind that printing money and running deficits for a long, a very long time, has not exactly been very successful in creating inflation in Japan, let alone hyperinflation.

Anyway, since we are interested in the mechanisms of inflation and not content with axiomatic assertions, I will explain why a rising inflation trend is far away. First, there cannot be any sustained rise in inflation without a sustained increase in inflation in nominal wages. Unit labor costs are the dominant influence on inflation in the long run (see chart below).

Low labor cost inflation is the main reason why headline inflation has been relatively low even when commodity prices were zooming in 2007-2008, unlike what happened in the 1970s and early 1980s. Take a look the following chart of PPI (producer price index) broken up by stage of processing. Crude goods inflation has been almost as high as in the mid 1970s reflecting commodity price rises, whereas in finished goods, where the labor input is predominant, inflation did not rise as much as back then.



Now, let us look at compensation inflation, which is the main driver of unit labor costs (productivity is important at low levels of inflation, but if we are talking about raging inflation, changes in productivity are insignificant). The ECI, published by the Bureau of Labor Statistics (BLS) is the most comprehensive measure of compensation costs. It is broken into wages and benefits. I show below wages and total compensation.


Unfortunately, the series gos back only to 1976. Nonetheless, the basic point is clear. Compensation inflation is low and declining. Of course, rising unemployment rate is putting immense downward pressure on wages. Back in the 1970s, even with high unemployment, was inflation remained at high levels and did not start coming down until Volcker jacked up interest rates to 20%, creating what was then the worst recession in the postwar era. Higher levels of unionization, oligopolistic industries, and limited global competition meant that workers could ask for and get pay raises to compensate for inflation, thus sustaining the wage-price spiral. Fat chance of that happening today. Also, the overall unemployment rate covers up a major distinction between the 1970s--a distinction that goes to the heart of why workers had more bargaining power back then. Take a look at the unemployment rate of men over 25.

Compared with the 1970s, the unemployment rate of men over the age of 25 is much worse today. The overall, unemployment rate in the 1970s was driven by a huge increase in the labor force--thanks to baby boomers and an increase in the participation rate of women. The economy actually created a huge number of jobs but was overwhelmed by the increase in supply. Unemployment was disproportionately concentrated in the recent entrants. Older, experienced workers had more stability and thus greater bargaining power. That is certainly not the case today. Today's situation, like the early 1980s, suggests a steep decline in wage inflation (see the ECI chart). Given where it is starting from, outright deflation wages is very likely.

Lastly, if you look at the chart of ECI, which plotted along with the unemployment rate, you can see that to get wage inflation trending up again, the unemployment rate probably needs to come down to 5 percent or lower range. The unemployment rate today is at 8.9% and rising sharply. After the last recession, it took about 2 and a half years after the official business cycle trough (November 2001) for the economy to start adding jobs. The Fed started to hike rates only after that. And this was in the midst of a housing bubble. We may well not see job growth before 2011. Even if we do, it will take much longer to get the unemployment rate down a number that is see as politically acceptable and potentially inflationary down the line. Yet, the market has convinced itself that inflation is just around the corner.