11th July 2017

Once again central banks made all the headlines. While the Fed have for some time been sending hawkish signals in the face of weakening inflation data, recently the ECB jumped on the bandwagon. Spooked no doubt by the markets’ reaction to Draghi’s Sintra comments, the ECB moved quickly to quell fears of imminent balance sheet reduction. With bond yields in Europe continuing to push higher however, the markets clearly didn’t buy it. If this had some investors confused, the Fed it seems are equally perplexed by the absence of meaningful wage growth in the US economy. Whilst the labour market remains ‘tight’, growth in wages simply isn’t coming through and inflation continues to underwhelm. There are we believe several reasons for this, which we will examine in a moment, but the pertinent question is why the more hawkish tone from the Fed? It was perhaps instructive that on the day following Draghi’s aforementioned speech, Richard Williams of the San Francisco Fed noted the stock market ‘seems to be running on fumes’ whilst separately Janet Yellen remarked asset valuations were ‘somewhat rich’. A signal to the markets they may be getting ahead of themselves. Indeed they might do well to heed the warning. If these concerns fall on deaf ears what type of drastic action might the Fed feel compelled to take?

Labour Market

Examination of the underlying dynamics of the US labour market and job creation post 2009/10 tells us much about the changing nature of the US economy and why a sizeable uptick in wage pressure is unlikely. Firstly, since 2010 there has been a discernible shift towards lower skilled, service based jobs away from skilled and higher paid employment. Of the approximately 16.5 million jobs added over that period, the vast majority offer below average wages and below average hours worked. Where highly skilled jobs do exist, companies are struggling to fill them. The Jolts jobs indicator shows over 3 million jobs available in that space with a lack of skills the reason many of these jobs remain unfilled. Thirdly, the participation rate remains at post-recession lows and close to all-time lows. There are currently 102 million working-age Americans not in employment.  With structural factors in terms of technology and globalisation contributing to much of this, it may be a long time before this trend reverses itself and perhaps it never will. Given the nature of post-crisis labour market, the traditional relationship between wages and unemployment as measured by the Phillips Curve may be a lot less robust than it has been historically.


The Fed’s assertion that falling inflation is a temporary phenomenon is also very curious. While there have been a number of transitory factors moving the inflation dial lower, the Fed’s own inflation gauge, the 5 year forward breakeven inflation rate (the markets’ indication of what inflation will be in five years), has been falling. This appears to be pointing to something longer term than the Fed are currently alluding to. The shape of the yield curve with its flattening biases once again point to some negative influences on inflation expectations. We would also question whether the Fed would really be worried about the inflationary impact of a potential increase in wages. Surely this should be welcomed.  For a while at least, this could help the economy really recover from the explosion in debt creation seen over the last two decades, which incidentally, coincided with next to no real wage growth. The concern we have is that central banks appear to be talking ‘tighter’ at a time when demand for credit and credit itself is starting to slow. As we have mentioned in the past, the recently published UBS credit impulse chart which covers credit for 77% of the global economy, has shown a marked decline of approximately 17%, a fall on par with 2008, albeit from a higher starting point. We have seen C&I, auto and credit card loan demand start to decline. This is unusual given how loose financial conditions continue to be. Credit expansion is an absolute must for an indebted global economy, and it is very surprising that the Fed would be tightening conditions in this type of environment.

Fed’s Dilemma

The Fed have a real issue here. In the aftermath of the last two boom bust cycles, it was clear who was taking the fall. The dot-com bubble was blamed on investment bankers specifically, and the housing crisis on bankers and the finance industry in general. As for the next bust however, there will be nowhere for the Fed to hide. Central banks have increasingly found themselves in the firing line over the past 12 months, from politicians looking to score valuable political points. Whilst they like the money printing and easy policy, politicians also want someone to blame if the situation goes south. It appears then that central banks are somewhat exposed at present with risk assets continuing to diverge from economic fundamentals. All discussion about the unwinding of the balance sheet at the Fed points to a level of concern – both with the need to dampen ever-growing asset bubbles, and/or to build protection for the next recession, given that current expansion is beginning to look a little long in the tooth.

By Steven O’Hanlon


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