The Daily Update - Inflation, Phillips curve

Ahead of today’s CPI data in the US, Federal Reserve Governor Lael Brainard was speaking at an event in Washington yesterday. She warned that ‘There does seem to be a very important, persistent, underlying trend in inflation, and there, a lot of the time-series work would suggest that we have actually seen a reduction in the underlying trend rate of inflation that’s material.’ Governor Brainard, who sits on the dovish side of the FOMC, has been a governor since June 2014.

She also noted that ‘Temporary factors seem to be an important explanation. But just as this year we saw temporary factors driving inflation down a bit, we saw temporary factors last year driving them up a bit. So that too cannot fully account for what we’ve been observing in the inflation data’, adding ‘some market-based measures of inflation compensation show the same kind of reduction’. ‘There seems to be a global factor there as well, but I don’t think that in itself explains what’s going on in the inflation process domestically’, and on the continuing debate regarding the Phillips Curve, ‘It’s not so much that the Phillips Curve isn’t operative, it seems to be that the Phillips Curve is just not very important in the overall inflation process’ she said.

The Phillips curve is an economic concept developed by A. W. Phillips, first published in 1958. It shows that inflation and unemployment have a stable and inverse relationship, broadly, it states the change in unemployment within an economy has a predictable effect on price pressures. Now this concept is being questioned given the employment situation in the US and the inflationary outlook the relationship seems to have broken down in today’s economy with massive QE and alternative monetary tools over the past several years distorting what historically has been an academic given. The debate continues, but it is these past relationships that investors continue to use, i.e. unemployment falls and wages go up so inflation goes up and therefore bond yields need to be higher. Rather strangely in our industry we still like to remind investors ‘that past performance is no guarantee of future performance’ and yet constantly look backwards to forecast the future, maybe the world has changed and historical tools do not work consistently in a modern day dynamic economy.

Inflation was also the topic of the day in Europe as ECB President Draghi noted that the guidance on interest rates, which says that they will remain at present levels ‘well past’ the horizon of net asset purchases, is ‘very important.’ Prior to President Draghi’s comments, ECB Chief Economist Praet called inflation pressures ‘still too weak’ and noted they have failed to show ‘convincing signs of an upward trend.’

The inflation debate continues and we retain our long duration stance across our funds.