– Invesco: Financial markets have reacted strongly to the election of US President Donald Trump. While equities in the US and elsewhere have risen strongly (reflecting expectations of stronger growth and therefore improved corporate earnings), bond prices have fallen (reflecting higher yields, in turn a result of higher inflation expectations).
As debate continues around President Trump’s fiscal stimulus program, a key question has emerged: What role might his policies play in creating inflation?
Among the main drivers of higher inflation expectations, one is the idea that a larger fiscal deficit will inevitably lead to higher inflation. The Trump program calls for higher defense expenditures and increased infrastructure spending. The perception in the financial markets is that fiscal spending and tax cuts add up to higher deficits, which would almost certainly imply higher inflation.
The last time such a major fiscal spending program with substantial increases in defense spending and enlarged deficits occurred was under President Ronald Reagan. However, although the budget deficit surged from 1.3% of GDP in 1980 to 5.9% by 1986, inflation actually fell steeply during this period, as the tightened monetary policy of the time aimed to lower the persistent double-digit inflation of the late 1970s and early 1980s. In other words, fiscal policy is not inflationary unless it is also accompanied by a surge in monetary growth. The clear implication is that unless monetary growth surges from its current (and very modest) growth rate, the risk of inflation is being grossly exaggerated by market participants.
A second theory of inflation that is popular among academics, central bankers and financial market participants is that there is a strong relationship between the level of available capacity in the economy and the rate of inflation. Sometimes the amount of spare capacity is represented by the output gap, the level of capacity utilization or the unemployment rate. These variants of inflation theory are collectively known as “Phillips curve” explanations of inflation.
The statistical problem is that these relationships have an extremely varied track record. The Phillips curve relationship is more an empirical observation than a theory of inflation. In reality, its components — measures of labor market tightness and inflation or wage increases — are both affected by money and credit growth, although other factors may also play a role. Typically, as the business cycle expands, employment rises (or unemployment falls), and inflation will rise in the late stages of such an expansion. Monetary expansion is the underlying driver of these increased expenditures that in turn tighten the labor market and push up inflation. However, idiosyncratic factors may occasionally affect unemployment and inflation, causing the Phillips curve relationship to go awry.
So why are widening fiscal deficits and the Phillips curve not reliable predictors of inflation? The reason is that inflation and deflation are fundamentally monetary phenomena resulting from excess or inadequate growth of the quantity of money for a sustained period of time. While rising fiscal deficits or falling unemployment may accompany faster money growth, on their own they are neither a necessary nor a sufficient condition for a sustained increase in inflation.
So is monetary growth really a superior predictor of inflation in the broadest sense? Of course there is also controversy among economists about the relationship between money and inflation, but when properly understood and applied, it is a far more dependable relationship over most business cycles than either the fiscal deficit or Phillips curve theories of inflation.
Meanwhile, the rates of growth of money and credit — and wider measures such as shadow banking credit — remain at subdued levels and are not enough to permit a sustained rise in the US inflation rate. This implies that the current business cycle expansion has several more years to run before the Federal Reserve needs to start tightening rather than normalizing rates.
Please check back for new articles and updates at Commoditytrademantra.com
For More details on Trade & High Accuracy Trading Tips and ideas - Subscribe to our Trade Advisory Plans. : Moneyline