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Why an Unpleasant Inflation Surprise Could Be Coming

The Wall Street Journal. logo The Wall Street Journal. 2/28/2018 Greg Ip

Inflation is going to head up this year—on that there isn’t much debate. The real debate is over whether it will be a nonevent or something more ominous.

The Federal Reserve and most of Wall Street think it will be a nonevent. But there is a plausible scenario in which it marks a new, dangerous trend. Even if you think it unlikely, you need to give this scenario serious thought because trillions of dollars of investments are geared to inflation being dead.

Unemployment in the last year has sunk to a 17-year low, yet inflation continues to run below the Fed’s 2% target. Abroad, it is the same story: in Germany and Japan unemployment is at multidecade lows but inflation remains stuck below 2%.

a man wearing glasses© Andrew Harrer/Bloomberg News

This disconnect is one reason Fed officials devoted much of their late January meeting to discussing what drives inflation. That is a bit like NASA debating what causes gravity: it is a bit unsettling that something so important can stump the experts.

Ironically, within days the missing inflation reared its head. Wage and price data firmed noticeably. The “core” consumer-price index excluding food and energy rose 1.8% in January from a year earlier and should soon top 2% as favorable readings from a year ago drop out of the 12-month calculation. The Fed focuses on a different gauge which is running lower, at 1.5%. But some economists think it, too, could hit 2% this year.

The consensus is that inflation will then level off, in great part because the public has come to expect 2% inflation and should set prices and wages accordingly. This is a sound and persuasive base case. But multiple forces are now at work that could, together, keep it going up. The most important is that unemployment at today’s low levels has over the postwar period typically coincided with rising price pressure. Second, a big tax cut and a federal-spending boost are about to juice the economy and potentially push unemployment even lower. Meanwhile, a falling dollar and rising oil prices are feeding through to other costs. On Tuesday, Fed Chairman Jerome Powell said “headwinds…have turned into tailwinds.” He was talking about the economy, but it is equally true of price pressure.

On top of these short-term factors, several structural forces are at work, as a recent report from BCA Research, a Montreal-based investment advisory, shows. One is protectionism. Global trade rose faster than global output from the early 1980s until the global financial crisis. Trade held down prices and wages by exposing American workers and firms to intense foreign competition. Globalization has since gone into reverse, and protectionist pressures are mounting: Americans can expect to pay more for washing machines and softwood lumber and perhaps soon anything containing steel or aluminum because of tariffs imposed by President Donald Trump.

Productivity growth, the usual antidote to rising costs, is tepid and could stay that way. BCA argues the so-called “Amazon effect” is overblown. Except for department stores, retailer profit margins have been rising, meaning they are not facing serious pricing pressure from online competitors.

If inflation turns up, economists have long assumed it would do so slowly, giving the Fed plenty of time to respond. But Michael Feroli of J.P. Morgan notes this assumption is built on models in which the world behaves in a predictable, linear way. In fact, he says, the world isn’t linear and inflation can change suddenly for unexpected reasons: it “is sluggish and slow-moving, until it isn’t.”

A case in point: in 1966, inflation, which had run below 2% for nearly a decade, suddenly accelerated to over 3%. Some of the circumstances echo the present: unemployment had slid to 4%, taxes had been cut and federal spending for the Vietnam War and Lyndon Johnson’s “Great Society” programs was surging. Deutsche Bank economists note the budget deficit jumped by more than 2% of gross domestic product between 1965 and 1968, similar to what they project between 2016 and 2019. Except in recessions, stimulus of this size “is unprecedented outside of these two episodes,” they said.

The effect of an overheating economy was then compounded by policy errors. Fed chairmen William McChesney Martin Jr. and Arthur Burns were too optimistic about how low unemployment could go without pushing prices higher, and succumbed to pressure from Johnson and then Richard Nixon to keep interest rates low. From 1966 to 1981, inflation and interest rates climbed to double digits, decimating stock and bond values.

Some on Wall Street worry Mr. Trump, who treats the stock market as a report card on his presidency, will similarly pressure Mr. Powell. So far, this seems unlikely: Mr. Trump and his officials have asserted the Fed’s independence and no central banker, Mr. Powell included, wants to be remembered as another Arthur Burns.

Yet even without politics, the Fed faces growing clamor to replace or relax its 2% inflation target. Advocates say higher inflation and thus higher interest rates provide more room to cut when the next recession hits. But inflation doesn’t have to top 4%, much less 10%, to wreak havoc: a world in which inflation risks persistently point up instead of down would drive bond yields higher and kick the support out from under stock and property values.

This scenario seems remote right now. But if you had given inflation up for dead, it is prudent to consider the consequences if it turns out to have only been sleeping.

Write to Greg Ip at greg.ip@wsj.com

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