The latest US inflation numbers are worrying the wrong people for the wrong reasons.
March’s weak report on the consumer price index showed inflation to be low, throwing out investors’ assumptions about inevitable rate increases from the Federal Reserve and raising fears that economic growth would remain in the doldrums.
But that anxiety is misplaced. Households’ finances now look strong. Low inflation is primarily a concern for corporations, which are seemingly unable to raise prices and hence protect profits.
When households and the labour market were weaker than they are today, low inflation was more of a broad-based economic concern. Early on in the economic recovery from the last recession, the job market was weak and households were reducing debt after a borrowing binge during the heady mid-2000s.
At that point in the cycle, deflation would have increased the effective debt burden of households, leading households to want to reduce debt even further, crimping consumption and keeping the economy and labour market in an impaired state.
Instead, the US economy enjoyed years of low interest rates, allowing households to refinance and bring their debt-service burdens to record lows. At this point, a slip into deflation shouldn’t lead households to reduce consumption or pay down debt in a significant way.
That, combined with a low level of unemployment, has led to higher consumer confidence, prompting consumers to borrow and spend and prompting workers to negotiate higher pay. As the unemployment rate continues to dip to new lows, more workers will have more bargaining power, and more workers will realise it and exploit it.
This gives employers a few choices.
They could let workers leave, and suffer the lost output. They could let workers leave, and hire replacements at prevailing market wages. They could raise prices for goods and services to support higher wages for workers — an inflationary action that should protect profit margins.
Or they could raise wages but hold prices constant, leading to no additional inflation but instead a drop in profits.
Falling unemployment, slowly rising wage growth, and no increase in inflation implies that final scenario is what’s playing out — wages up, prices flat, profits down.
Over the long run this is unsustainable for businesses, because no business can withstand a perpetual increase in the price of its inputs, in this case labour, without being able to pass on some of that cost growth to its customers.
Fortunately for corporations, profit margins are near multi-decade highs, so they have a cushion to accept lower profit margins as workers gain bargaining power. At the same time, those higher profit margins have powered earnings growth, and hence stock market valuations.
Take away the juicy profit margins, and earnings will fall, and with them, stock prices.
As the glow of the post-election rally fades, this realisation may dawn on investors. We’ve seen this already in the more labour-intensive industries with low profit margins like restaurants and retailers, and there’s no reason it should stop there.
The Federal Reserve’s April Beige Book noted wage growth and labour shortages were broadening out across the economy.
Markets and investors tend not to have memories beyond the past couple of cycles, and seek to avoid the pain those cycles caused. In 2017, that means large “negative demand shocks” like we had in the 2001 recession and the 2008 great recession.
Yet following both of those recessions, corporations discovered they had increased bargaining power over their employees, leading to stagnant wage growth but soaring profit growth.
This current situation is different — seemingly unprecedented: full employment with subdued inflation, giving workers the upper hand and putting sustained downward pressure on profit margins. It might not blow up the economy, but it may blow up the earnings statements of corporate America.
