Gary Shilling Makes the Case for Low Inflation

(Related: Most Fed Officials Backed Continued Gradual Rate Increases)

Shilling stresses the importance of the labor force participation rate, which includes not only those who are employed but those who are actively seeking jobs. It peaked at 67.3% in 2000 and has stagnated below 63% since 2013 (It was 62.7% in December 2017). "Without this precipitous drop in the [labor force participation] rate, the headline unemployment rate, now at 4.1%, would be in double digits," writes Shilling.

The U.S. labor market isn't tight, but the Fed and other economists who focus on the unemployment rate believe it is, according to Shilling.

"Consider reality," writes Shilling. "Since the Great Recession, both the U-3 unemployment rate and CPI inflation have been falling … Consider Japanese unemployment. It's the lowest in decades and labor shortages are rampant … yet average monthly real cash earnings fell in the last year and rose a tiny cumulative 0.9% in 2007-2008…. Similarly, Germany has the tightest labor markets in two decades. Still, real pay gains remain below 2% at annual rates."

Shilling expects the Fed and other major central banks will continue to shift policy from credit easing to tightening even though in the Fed's case "inflation and wage increases continue to undershoot its expectations."

"There are pressures for credit-tightening including the Fed's steadfast belief in the Phillips Curve, excess global liquidity, gigantic member bank reserves, market distortions as investors react to low interest rates, the central bank's belief that rates should be higher, its credibility after chronically forecasting fed funds rate increases and concerns over robust economic growth resulting from the tax cuts and future fiscal stimuli," writes Shilling.

But even if the Fed continues to raise rates, Shilling is not concerned about a recession, which has followed 11 out of 12 post- World War II rate-raising campaigns.

"This time, the pattern may be stretched out due to the Fed's long delay in action due to the sluggish economic recovery and persistent low inflation. Also, there's so much excess liquidity around the world due to earlier low central bank rates and quantitative easing that it may take years before higher fed funds rates and reductions in the Fed's assets start to pinch the economy."

The yield curve may also react differently this time. Instead of long-term rates rising as the Fed hikes short-term rates, 10-year and 30-year Treasury yields have been falling. "A further narrowing of the yield spreads or even a yield curve inversion may not signal an imminent recession but instead reflect the robust deflationary forces we see worldwide and their depressing effects on long-term Treasury yields," writes Shilling. He still favors Treasuries, which remain "one of the few safe havens of any size in a world of ongoing uncertainty. And their yields are attractive relative to the lower or even negative yields of sovereigns in other developed countries."

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