Is This The End Of Correlation Between Inflation And Unemployment?

Inflation and unemployment are often considered to have an inverse relationship. When employment rates are low, there is competition for workers and wages go up, assuming supply and demand markets are functioning. But with unemployment at 4.1% in November, its lowest rate since 2000 and beyond what the US Federal Reserve officially considers a sustainable long-run rate, inflation “has continued to disappoint,” a Goldman Sachs report noted. What will this mean for Fed rate hikes in 2018? The Goldman report comes as Bank of America Merrill Lynch also noted that the historic relationship between unemployment and interest rates, as measured in the Phillips Curve, might be weakening.

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Inflation and unemployment: With inflation limping along will the Fed raise rates?

The Fed is eying three rate hikes in 2018, its own dot plots project. But with inflation limping along – it hit a near-term low in August at 1.3% -- are rate hikes warranted? Will the traditional correlation between inflation and unemployment hold?

Looking at market-based inflation expectations, Goldman’s US Economics and Rates Strategy team notes that ten-year breakeven inflation expectations are at 1.9% now, down from 2.08% post-election when the potential for fiscal stimulus was on the table.

These muted projections are having an impact across the yield curve.

“The inflation options market also prices CPI inflation to remain close to the Fed’s target and assigns historically very low chances of upside inflation surprises,” the Goldman report observed. “This lack of concern about inflation risk has helped reduce the term premium—the extra compensation for holding longer-dated bonds exposed to larger price fluctuations—lower interest rate volatility, and flatten the yield curve.”

But the outlook heading into 2018 may be, in part, riding the momentum of 2017.

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Inflation and unemployment: watch for a 3.5% unemployment rate and low inflation. Really.

As 2017 prepares to fold into 2018, headwinds to inflation, while not rip-roaring, are nonetheless “stabilizing.”

“Downside risks to shelter inflation” have stabilized as the housing market improved, and the auto market has been temporarily buoyed by vehicle damage during the hurricane season. Unlike the popular meme on the “Amazon effect” on prices, this likely won’t be a major factor as “this effect is probably smaller today than during previous periods,” clocking in at a relatively benign 0.1% impact on core PCE inflation.

It is in this environment that Goldman sees a Goldilocks environment winning the day.

They think unemployment can fall further, ratcheting down to 3.7% in 2018 and as low as 3.5% in 2019. And that inflation that normally picks up with a decline in unemployment?

Following one of the tightest labor markets in postwar history, in 2018 Goldman expects inflation to accelerate to 1.7% and 1.9% respectively – under the Fed’s 2% target. While low inflation is Janet Yellen’s “biggest surprise,” does the Fed need to raise rates to combat inflation? Or are they looking to boost their toolkit in case another financial storm hits?

Goldman looks at incoming Fed Chair Jerome Powell much the same as they do Yellen, expecting a similar policy framework and one hike each quarter. Four rate hikes in 2018 and the reduction of another $400 billion in the Fed’s balance sheet is likely to “put upward pressure on the term premium, lifting longer-dated yields and interest rate volatility.” Goldman expects 10-year yields to pierce the 2.61% level and end 2018 at 3%, a move expected to leave the yield curve steeper.

The moves higher in yield are part of a risk skewing that favors such upside, and the moves could be influenced by developed market central banks in Europe and Japan.

“As the Fed increases policy rates to levels above the 2% inflation target, we anticipate greater pressure on the ECB and the BOJ to remove negative rate policies,” Goldman predicted. “This could, in turn, have negative spillovers on US intermediate-maturity yields, resulting in an even steeper curve than we project.”