Bond investors, your time is up. Four consecutive months of weaker-than-expected inflation excited buyers, helping them rationalize the unrealistic heights reached in the bond market even though the underlying economic fundamentals are simply inconsistent with prevailing interest rates. That’s something the Federal Reserve fully appreciates, but investors don’t.
Many people, including Fed Chair Janet Yellen, have been surprised by the recent slight moderation in inflation. It’s inconsistent with any known economic theory, and almost impossible to rationalize. But this also means it could reverse just as quickly without explanation. It could simply be an outlier and we are simply returning to more normal behavior.
Start with the labor market, because it broadly crosses all industries, all population groups, all regions, and every part of the economy. Any objective reading of the data indicates that labor is scarce. More growth might only squeeze out some incremental supply, but not enough to undermine that conclusion. Job openings are at record highs. Layoffs are at record lows. Job growth remains above labor-supply growth, so the scarcity will only worsen.
The economic background is very favorable for continued growth. Labor scarcity may force companies to increase capital investment to enable firms to substitute capital for jobs. Since corporate profits are doing well, businesses can afford such investment outlays. Spending will only help reinforce the expansion and the demand for labor.
The Trump administration would love to reduce taxes, increase spending on infrastructure, and reduce regulation. Dysfunction in Washington has prevented much of substance from making its way through the approval process, at least so far. But it is unrealistic to think that absolutely nothing will happen. And any progress implies a more stimulative fiscal policy that will spur growth.
Globally, central bankers have been pulling out all the stops to promote healthier economic recoveries, notably in Europe and Japan. The European Central Bank is preparing the market for a tapering of its quantitative easing monetary policies as growth firms. Japan is also performing better. The U.K. will soon be raising interest rates. A global economic expansion tends to be mutually reinforcing, as healthier growth in Europe implies more demand for imports from the U.S. At the same time, solid growth in the U.S. implies stronger demand for imports from those regions. This will also make it harder to disrupt.