U.S. Inflation Rate Forecast Looks Ominous
The U.S. inflation rate forecast for the next five years shows signs of overheating. This could portend bad news for a U.S. consumer who is sensitive to both purchase power and interest rates.
A confluence of factors is to blame for this foul-smelling potpourri. The looming ghost of input price inflation, currency wars, and massive governmental debt worldwide is the primary culprit. This tectonic shift in inflationary dislocation has not gone unnoticed either.
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Among the early adopters of the higher U.S. inflation rate forecast for 2017 trade was Kyle Bass. The Hayman Capital Management, LP founder placed one of his biggest bets in 2017 on higher inflation in his third Asia-focused fund. In his letter to investors in early January, Bass stated, “As we enter 2017, we believe enormous macro imbalances are just beginning to unwind.” He went on to say that, “Global markets are at the beginning of a tectonic shift from deflationary expectations to reflationary expectations [Emphasis added].” (Source: “Kyle Bass: ‘Global markets are at the beginning of a tectonic shift’,” Yahoo Finance, January 4, 2017.)
For those choosing to turn a blind eye to Bass’s predictions, be aware that he is one of the world’s top-rated hedge fund managers. His fund has a stellar history—up 436.75% on aggregate, translating to a 16.70% annualized return since inception in 2006. Bass’s prognostications are correct more often than not, and his viewpoints are closely watched around the globe.
But this consumer-busting inflationary vortex is just getting started, and Bass’s predictions are starting to get detected in U.S. consumer price data.
After years of keeping the federal funds at near-zero, the U.S. Federal Reserve finally received the interest rate predictions 2017 that it was seeking. In January, the U.S. cost of living increased by 0.6% on a seasonally adjusted basis, its biggest jump in four years. Year-over-year, inflation increased by 2.5%, the biggest gain since March 2012. (Source: “Consumer Price Index Summary,” United States Bureau of Labor Statistics, February 15, 2017.)
In fact, owing to rising inflation rates, the Fed rate odds have jumped to over 90% for March, from about 30% earlier in the month. This, despite a previously sanguine U.S. GDP rate forecast 2017 of 1.9%. One of the main reasons cited for the interest rate prediction jump: you guessed it, higher consumer inflation.
So what rate of inflation is good or acceptable? According to the Federal Reserve’s inflation rate formula, the number is two percent. The Fed deems two-percent inflation as the level most consistent with achieving its mandate of price stability and full employment over the long term. As inflation has persistently undershot its optimum threshold for almost a decade, current U.S. inflation rates are forcing it to act.
U.S. Inflation and Unemployment Rates by Year (since 2000)
| Year | U.S. Inflation Rate by Year | U.S. Unemployment |
| 2000 | 3.4% | 4.0% |
| 2001 | 2.8% | 4.7% |
| 2002 | 1.6% | 5.8% |
| 2003 | 2.3% | 6.0% |
| 2004 | 2.7% | 5.5% |
| 2005 | 3.4% | 5.1% |
| 2006 | 3.2% | 4.6% |
| 2007 | 2.8% | 4.6% |
| 2008 | 3.8% | 5.8% |
| 2009 | -0.4% | 9.3% |
| 2010 | 1.6% | 9.6% |
| 2011 | 3.2% | 8.9% |
| 2012 | 2.1% | 8.1% |
| 2013 | 1.5% | 7.4% |
| 2014 | 1.6% | 6.2% |
| 2015 | 0.1% | 5.3% |
| 2016 | 1.3% | 4.9% |
| 2017 | ??? | ??? |
(Source: “Historical Inflation Rates: 1914-2017,” U.S. Inflation Calculator, last accessed March 6, 2017; “Unemployment rate in the United States from 1990 to 2016,” Statista, last accessed March 6, 2017.)
Based on the above data, it appears the Fed has been mostly successful in achieving its target inflation rate forecast and full employment mandates. But for how long? The causes of inflation are different this time around, and could force the Fed to perform the third leg of its mandate: normalizing long-term rates.
What is the average rate of inflation in U.S.? Historically, it’s about 6.4%. If is gets anywhere near this level with today’s governmental indebtedness, some very serious consequences loom in the background.
U.S. Inflation Rate Forecast for Next 5 Years
So with inflation invariably picking up, what will the inflation rate be in five years? According the alphabet soup of government agencies, everything will be just fine.
And that’s precisely what troubles us most. When government institutions give the all-clear, quite frequently, the opposite occurs. Who can forget former Chairman Ben Bernanke’s calming platitudes right before the U.S. housing bubble collapsed?
In a December 2016 Federal Open Market Committee (FOMC) meeting, the Fed governors predicted that inflation would rise to the long-term target of two percent over the next couple of years. This is wholly consistent with the International Monetary Fund (IMF), United Nations (UN), European Commission (EC) et al. who predict similar, but slightly more bearish inflation levels of between 2.1%–2.6% for 2018. (Source: “US Inflation Forecast 2015-2020 and up to 2016, Data and Charts,” Knoema, last accessed March 5, 2017.)
What’s unclear is whether these projections have factored in the Trump election win or not. This matters immensely, as inflation rates will largely hinge on whether Trump throttles free trade by instituting border taxes.
Of course, Trump has free-market economists in a tantrum over his threats to impose tariffs on all foreign imports. These aren’t just idle threats, either. Trump has repeatedly extolled the intention of imposing crushing tariffs of up to 35% on goods from a broad range of industries.
Such actions would certainly lead to input price inflation. This occurs when the cost of raw materials (inputs) rise in price, thus leading to higher finished goods prices down the supply chain. If freely traded raw materials and commodities become pawns of a larger global trade war, not only high prices, but supply shortages could easily result.
Other commodity-producing nations would surely retaliate to punitive tariffs imposed at the border.
One such example of risk to input price inflation could be rare earth elements (RE). Back in 2010, the Chinese lowered quotas on exports of rare earth elements. This caused a significant problem, as the U.S. depended on China to supply many of the REs that are critical to its high-tech and defense industries.
If China were to retaliate to upcoming present-time U.S. tariffs, the price of REs could skyrocket (as in 2010), when then-Secretary of State, Hillary Clinton, called the situation a “wake-up call.” Not even a favorable World Trade Organization (WTO) decision could bail them out this time. (Source: “5 years after crisis, U.S. remains dependent on China’s rare earth elements,” E&E News, January 12, 2015.)
Input price inflation also reared its ugly head in 1973, due to the Organization of the Petroleum Exporting Countries (OPEC) oil embargo. A constricted supply of crude oil led to massive energy price hikes, causing a domino effect down the supply chain.
This is when inflation took a turn for the worse. In 1972, U.S. inflation chimed in at 3.2%, which was at a five-year low. By the end of 1974, average U.S. inflation reached 11%, which was the second-highest annual inflation number since 1920. Consumers throughout America were feeling the pain known as stagflation. Basically, consumer prices were rising much faster than wages, causing a constriction of purchasing power.
Unfortunately, the pain continued throughout the later 1970s and early 1980s, averaging no less than 5.8%, when Fed Chairman Paul Volcker finally managed to slay the beast by raising the federal funds rate to a peak of 20% in June 1981.
Nobody wants to revisit those times.
There’s also the curious threat of wage price inflation, despite the fact that 93 million workers are out of work. This reflects a scarcity of highly skilled workers more than a reflection of the size of the labor pool itself. It turns out that workers, like perishables, have an expiry date as well.
Average wages grew by 2.9% in December, providing some preliminary evidence that labor costs are on the increase. In fact, this was the fastest increase in worker pay since 2009, and probably close to the level the economy can sustain without triggering higher inflation.
Gains in wages should be sector-specific this time around. So, while automation of replaceable human labor will mean that the cost of a Happy Meal remains in check, goods made with highly skilled labor will probably rise asymmetrically. This doesn’t bode well for inflationary trends for goods emanating from sectors like technology, health care, engineering and select manufacturing.
This will especially be the case in construction, if Trump’s policies are able to convince dozens of multinationals to onshore production back to America. Trump has already cajoled several multinational companies to either keep manufacturing in the U.S., or build new factories within.
The threat of skilled labor shortage-induced wage spiral is credible. Now, if we couple this plausible sequence of events with input price inflation, prices can run much hotter than anyone suspects.
In one of many such examples, International Business Machines Corp. (NYSE:IBM) announced in December 2016 their intention to hire 25,000 new workers in the U.S. during Trump’s first term in office. IBM also committed $1.0 billion for training and developing of U.S. employees, which would surely offer some economic spin-off effects on peripheral industries.
However, the quote from IBM CEO Ginni Rometty that caught our attention was on purported concern about the upcoming skilled labor shortage: “We are hiring because the nature of work is evolving – and that is also why so many of these jobs remain hard to fill.” (Source: “IBM boss promises 25,000 new American workers during Trump’s first term on eve of summit with tech bosses at Tower,” Mail Online, December 13, 2016.)
When CEOs of major multinational companies decide to spend 10-figure sums on job training instead of share buybacks, we know they are concerned about labor shortages.
Ultimately, the great difficulty is in assessing whether Trump’s rhetoric is Art of the Deal-type posturing, or a genuine attempt to rebuild the nation’s manufacturing base. If it’s the latter, people can expect base inflation to run much hotter than the alphabet soup that agencies suggest. U.S. consumers are so used to price stability that the normalcy bias is almost impossible to shake.
If there’s such a thing as executing a mandate too well, Trump may inadvertently be putting the U.S. consumer in a difficult position in 2018.
