In almost every 2018 outlook by Wall Street banks, inflation is mentioned as one of the biggest risks facing financial markets. Inflation will rise, the argument goes, because labor markets are tight and wages are increasing, which threaten additional Fed rate hikes beyond what’s already discounted in the market. Higher rates, in turn, would increase bond yields and slow growth.
Gary Shilling, founder of A. Gary Shilling and Co., an economic research and money management firm, doesn’t buy it.
“Inflation continues to undershoot the Fed’s 2% target,” writes Shilling in his latest market outlook, noting that Treasury yields, as a result, are not only not rising but also actually falling compared to year-ago levels.
Even after “the huge tax cut was enacted” and rates initially rose, the 30-year Treasury bond was yielding 2.82% on Dec. 26, compared with 3.06% at the end of 2016, writes Shilling. (It finished 2017 at 2.74%). In addition, the 10-year Treasury note finished 2017 yielding 2.4%, below the 2.45% of a year earlier.
“The consensus of economists almost always predicts rising Treasury yields and is almost always incorrect.”
Shilling has consistently forecast lower Treasury yields since 1981 when the 30-year Treasury bond was yielding 15.7% and he declared, “We’re entering the bond rally of a lifetime.”
He was correct about the rally and still argues for lower bond yields but also sees growth picking up in 2018 due to the stimulus from the tax cuts and expected increases in infrastructure and military spending. “The case for faster growth is strengthening.”
But the case for tighter labor markets and rising inflation is not, says Shilling.
“We see U.S. labor markets much lower than the Fed and many other forecasters who can’t understand why low wage growth and subdued inflation persist but believe that both are about to leap,” writes Shilling.
He explains that the headline unemployment rate, which is a focus of the Fed and other economists, misleads because it can decline not only when more people find work but also when fewer people are looking for jobs.