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Vince Foster: With Fed's Inflation Target, Be Very Careful What You Wish For


Rising inflation premiums and rising consumer prices in excess of wage growth is the single biggest risk to the economy and market multiples.

Friday's (March 7) better-than-expected February employment report was cheered by economists and market participants who laid to rest any fears of a weather-related slowdown. The headline non-farm payroll gain of 175,000 was better than the Street estimate of 150,000 with the more important private payrolls gaining 162,000 vs. the 145,000 estimate. The 162,000 gain in private payrolls follows the revised January gain of 145,000 and December 2013 gain of 86,000, but was well shy of February gains in 2011, 2012, and 2013 which were 223,000, 228,000, and 263,000, respectively.

While the payroll numbers were somewhat ho-hum, the number that jumped off the screen was the 2.2% gain in average hourly earnings. The total private average hourly earnings showed an even better increase of 2.5%, which is the highest growth rate of the recovery. Average hourly earnings have essentially flatlined at 2.0% since recovering from the recession, and many believe this is the best indicator of labo- market slack.

An uptick in earnings could indicate the labor market is tightening and provide fuel for an increase in consumption and inflation, which, in theory, would put pressure on the Fed to potentially tighten policy faster than expected. This interpretation was not lost on bond market activity that traded with a clear bear flattening bias with the belly of the curve leading rates higher.

However there is reason for a less sanguine assessment of the wage story. Minyanville's Michael Sedacca pinged me with a different interpretation of the jump in wage gains; he posited that the big drop in workweek hours was contributing to inflated growth. Sedacca pointed out that the weekly average hourly earnings were much more benign and in fact were showing a big deceleration in earnings to just 1%.

Average Hourly Earnings YoY Vs. Average Weekly Earnings YoY

It's not clear whether average hourly earnings or average weekly earnings is providing the better gauge of consumption capacity, however, later on Friday there was an economic release that may lend an indication. China released February data that showed a massive swing in the balance of trade, which dropped from a $32 billion surplus to a $21 billion deficit (vs. an estimate of a $14 billion surplus) with exports declining 18% vs. an estimate of 7% growth. It is conceivable that this decline in exports is a function of contracting US demand and could be the reason the People's Bank of China (PBOC) is open to a weaker CNY, neither of which are consistent with accelerating US wage growth.

Average Weekly Earnings YoY Vs. China Export Growth YoY

The diverging wage metrics is of major importance because the Fed is preparing to adjust forward guidance that may increase the focus on inflation. Following the report, comments crossed the wire from NY Fed president Bill Dudley that reiterated that Fed policy would remain accommodative. As this followed similar comments from Fed officials, it is becoming clear that the message coming from the Fed brass is that they are willing to overshoot on their inflation target in order to ensure their employment mandate is secure. The belief is that if the Fed is seen as credibly reckless with regard to inflation expectations, then it can achieve so-called escape velocity. The Financial Times' Cardiff Garcia reiterated this view in a post on Friday.

Our own position has been clear for months: Wait a while, even a long while. A period of catch-up inflation, especially if driven by wages, is just what is needed -- lowering real rates; further eroding debt burdens; incentivising people who are now out of the labour force, including many with high switching costs, to re-enter it; and convincing companies that they won't have to slash prices, with all the reverberations that can have for supply chains. Less importantly, it is also still the best test of labour market slack, and ultimately the only one that matters.
If the Fed, fearing the nascent hints of rising core inflation, signals that it will move forward in time the date when it will raise rates, then this self-perpetuating virtuous cycle of higher wages => more spending => more jobs => tighter labour market => higher wages is less likely to begin, or to prove sustainable if it does begin.

Here's the problem with this line of reasoning: The market will not allow the Fed to be recklessly easy without a cost. If the market gets the sense that the Fed is going to be purposely inflationary, then market premiums for inflation are going to increase. In order for a rise in inflation risks to not impact economic activity, wages would need to rise faster than inflation premiums filter through to consumer prices. This is highly unlikely and presents a heightened risk factor for the economy and risk asset prices.

Inflation premiums are the single most important market metric, and I have found that most market participants don't even understand how this impacts asset prices. The most important thing to realize is that you don't need to have high absolute inflation to have high inflation discounts. Just because inflation isn't nominally high doesn't mean it's not relatively high. When working off a low base of growth, even a slight spike in inflation can elicit a sharp reaction.

When Chairman Bernanke announced he was prepared to launch another round of QE at the August 2010 Jackson Hole symposium, the market got the message loud and clear. There was a clear bias toward asset reflation. The dollar weakened, the yield curve steepened, and hard assets rallied. Between August 2010 and March 2011, the commodity index (CCI) and the CRB food index both rallied over 40%.

CCI (Continuous Commodity Index)

It didn't take long for this inflation discount to trickle into actual inflation. In August 2010, the PPI YoY growth rate was 3.3% and by May of 2011 had doubled to 7.1% while the CPI had jumped from 1.1% to 3.1%. In theory there would be no concern with a 3.1% inflation rate, but when wages are only growing at 2.0%, this proved debilitating for the consumer.

I will never forget comments made by dairy producer Dean Foods (NYSE:DF) on its May 2011 earnings call:
So I think the most telling indicator for us that economic weakness and employment is the key issue driving soft volumes, is the fact that we continue to see, as -- in contrast to the historical norms, we continue to see volume pick up heavily at the beginning of each month, and then steadily erode through the month, being particularly soft in the last week to 10 days of the month. That just tells us that people are running out of money.

The company could tell that consumers were feeling the commodity pinch and were forgoing purchases of basic staples such as milk. The Fed got its inflation, but there was no corresponding increase in wages. In fact, arguably, the massive spike in producer prices was not able to be passed through to the weak consumer, and these rising costs were taken out of wages. There is no doubt in my mind that this was the primary reason the Fed opted to end QE2 in June of that year and later opted for the balance-sheet-neutral Operation Twist.

CRB Food Index

Since the QE-induced inflation spike in 2011, inflation has trended lower and remained subdued. The January readings for PPI and CPI were a benign 1.5% and 1.6%, respectively -- well below the Fed's inflation target. However, inflation pressures are starting to rear their ugly heads in the prices of agricultural commodities. Since the beginning of the year the CPI Food index is up 15%, which is over 100% annualized. The year-over-year growth rate has spiked from -14% to 2.9%. This is a sharp move in a short period of time and is just the kind of inflation pressure I warned about back in January in my article How the Prices of Corn and Copper Could Derail the Rally in Risk:

Recently Fed officials have expressed concern with the low levels of inflation, and there has been some suggestion of raising the Fed's 2.0% inflation target. I say they should be careful what they wish for. The last two spikes in inflation risk were in 2008 with oil and 2011 with corn. Both those episodes didn't pan out so well and were followed by a crash in risk assets. Today it's all quiet on the inflation front, and inflation risk premiums remain subdued. However, these risk premiums are dependent on commodity prices and the currencies of commodity producers such as the AUD and the BRL. These prices are all depressed and poised to reverse, which would put pressure on the dollar, inflation premiums, and risk premiums.

CCI Vs. Equity Risk Premium (Six-Month Lag)

The last two inflation spikes in 2008 and 2011 were both met with violent market responses. Risk premiums are vulnerable to a rapid rise in inflation risk because of the multiple investors are willing to pay for real cash flow. When inflation risk is low, multiples rise because investors are confident cash flow is real; when inflation risk is high, multiples contract because investors command compensation for real cash flow uncertainty. This is the pillar of multiple valuation.

It seems the rally in risk knows no bounds. It doesn't care about earnings, economic growth, eurozone debt crisis, government shutdown, monetary tightening, emerging markets, war, or natural disasters. I can't imagine there is an argument left that bears can cling to that hasn't already been debunked by this rally. Investors are comfortably long with no risk in sight. However, there are inflation clouds on the horizon.

Rising inflation premiums and rising consumer prices in excess of wage growth is the single biggest risk to the economy and market multiples. Inflation at 1.5% with 2.5% wage growth is good, but inflation at 3.0% with 1.0 wage growth is very bad. The Fed is preparing to give inflation premiums the green light. If prices start accelerating faster than wage growth, this low-inflation slow-growth economic recovery that has fostered a robust multiple expansion rally will be stopped dead in its tracks.

Twitter: @exantefactor
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