High Wage Inflation and Rising Interest Rates : Thinking of Second Order Effects

The rout in global markets last week has rattled investors across the world. The Dow Jones Industrial Average has corrected about 10% from its peak, forcing investors to sit up and take notice.

While I am definitely not a qualified economist and have very basic understanding of macro economics, in this post I would like to use some common sense and analyse what, why and how it happened. And more importantly, what now?

Apparently it all began with the US wage inflation numbers which were published last week. Average hourly pay was reported to have grown by 2.9 per cent over the previous year — the fastest pace since June 2009.

With unemployment numbers near all time lows and wage inflation numbers surprising on the upside, speculation began that Fed will have to move fast to increase rates to keep the inflationary forces at bay.

If yields move up, equity valuations are negatively impacted in following ways

1. Fixed income instruments will start looking more attractive to investors at large.
2. Cost of capital for firms moves up, thereby affecting their profitability and forcing investors to discount their future earnings at higher rates.

We all know that after the GFC, the Fed has increased it balance sheet size five folds by buying treasuries and bonds from market and it will now have to reverse the quantitative easing by selling these bonds back to investors. Such a process, if not done gradually, will create a huge upward impact on yields.

So in a nutshell, main reason for investors’ fear is the expectation of high inflation which may force the Fed to raise the rates faster than expected.

In theory, this is how it is supposed to pan out. But the relationship between wage inflation and yields may not be that straightforward.

When Fed and the US govt. see signs of inflation creeping up, what will they do? Will there be other forces which may work at the opposite end to reverse these pressure on wages and inflation?

Let’s analyse some counter intuitive point of views and second order effects.

• The relatively high wage inflation may not lead to high overall consumer inflation. That number is still at 1.5 percent, way short of policy makers’ goal of 2 percent. According to Joseph LaVorgna, Natixis chief Americas economist — in the previous two expansions, a surge in wages — sometimes topping 4 percent — failed to deliver or even coincide with a spurt in inflation. He says that to find that link, one would have to go back to 1985, adding that the correlation coefficient between wages and inflation since that time is “very low.” (Source: Bloomberg)

• If the investors still continue to panic and continue to bid the treasury yields high, it is a given that sooner or later, Fed will give reassurances to markets that it is going to raise rates slowly. Even if the inflation scare is for real, this will give them some breathing time to respond.
• After Donald Trump became president, he has talked a lot about restricting the number of immigrants to US. This has been followed up by tightening visa norms. If US economy faces any shortage of work force or high pressure on wage rates, Trump will not hesitate in reversing his stance by relaxing immigration policy and work visa norms. If the economy is growing and near full employment, he would find enough reasons to justify it. Also, he would prefer some negative press on flip-flop of stance on immigration policy to a stock market crash under his watch.
• One should not forget that US is known for its leadership in technology. Over the years, technology has helped the US economy increase its productivity enormously. There is no reason to believe that this trend will change any time soon. Which means that as the economy grows, it may continue to increase its productivity and hence the requirements for an active work force may not increase proportionately.

• US labor force participation rate has been falling as a lot of individuals stopped looking for jobs after the GFC. That rate has bottomed out over the last couple of years and with US economy picking up growth has now slowly started to move up. With wages growing and new jobs getting created, these job seekers may come back to market thereby increasing the supply of available work force and helping in arresting the trend of high growth rate in wages.

• It is well known that in US, both corporates and individuals have been deleveraging for last ten years. After deleveraging for so long, now some of them would become net savers and investors. They may look to invest their savings in fixed income instruments as yields become attractive. Also those who were savers, have had no incentives to invest in debt thanks to near zero interest rates over last ten years. Now with rates going up and equities turning volatile, there may be a shift towards more flows in fixed income instruments. This will help in keeping yields in check as the increased supply of bonds will be met by increased demand.

Considering all this, common sense tells me that while there is a possible and somewhat probable scenario that inflation and yields in US move up too fast, it is definitely not a certainty.