Throughout last year, investors worried about a phantom menace that could upset markets: higher U.S. inflation. They were wrong, to their own pleasant surprise. Now they could be right, which creates its own complications.
The key thing to consider is the power of expectations—perhaps the most important force in financial markets. For some, higher inflation has been a worry ever since global central banks engaged in extraordinary monetary policy. But consumer-price inflation has been puzzlingly absent: last year former Federal Reserve Chairwoman Janet Yellen labeled the behavior of U.S. inflation a “mystery.”
The fuss now might seem odd given headline inflation has been rising since its nadir in 2015. But crucially, it didn’t rise as much as expected last year, and a lot of the move was down to a rebound in energy prices. Economists, who help shape market expectations, persistently forecast higher U.S. inflation than actually emerged. That can be seen in Citigroup’s U.S. inflation surprise index, which has been in negative territory even as its eurozone and Japanese peers have picked up.
The lack of inflationary worries meant stronger global growth captured investors’ attention last year. Equity markets posted big gains, while fixed-income investors were remarkably relaxed about U.S. monetary policy, keeping long-term bond yields contained. Combined with better growth, particularly in Europe, the dollar weakened throughout 2017. That helped support risk appetite in emerging markets, brightening the economic outlook further.
But the backdrop has changed. The recent violent market swings started with an apparent pickup in U.S. wage growth. Added to that are concerns about U.S. tax and spending policy, piled on top of already loose monetary policy. Significantly, U.S. bond yields haven’t fallen even as markets have grown turbulent.
January inflation data out Wednesday is thus key. Economists polled by The Wall Street Journal expect headline inflation at 1.9% and core inflation, excluding food and energy, at 1.7%. If the numbers start overshooting expectations, markets could get another jolt. So many got inflation wrong for so long, that getting it right is its own form of surprise.
Write to Richard Barley at email@example.com