Concerns over inflation in the US are “misplaced”, according to Invesco Perpetual’s John Greenwood, who says that there are several more years of growth ahead. 
Following the most recent meeting of the Federal Open Market Committee, Federal Reserve chairman Jerome Powell made it clear that the central bank would continue to raise rates to head off the threat of inflation.
Yet, the Fed may be worrying over nothing, according to chief economist Greenwood (pictured), who said that rate-setters may be basing their inflation assumptions on outdated theories.
“Inflation concern is misplaced,” he said. “It’s based on two ideas. One is that the US labour market is getting very tight, and under the 'Phillips curve' theory when unemployment falls you typically get inflation.
“The other theory is concerned with the output gap, that when the economy reaches full capacity it tends to trigger cost pressures.”
Greenwood noted: “But the truth is that these things are happening after a period of fairly steady growth against a background of low money and credit growth.”
As a product of money growth, inflation is unlikely to trouble US authorities too much against such a backdrop, said the economist.
Regardless of inflation, Greenwood said that interest rates are likely to increase over the medium term as the US economy continues growing in the coming years at around 2-2.5 per cent per annum.
As Fed chair Powell’s comments over a rise in rates to 3.4 per cent by 2020 were digested by the market, the S&P 500 saw a sharp sell-off amid growing concerns of rates being hiked too quickly, as the below chart shows. However, Greenwood believes that there is little chance of a Fed policy mistake given the need to normalise rates after years of support for the financial system.
Performance of index in October 2018
Source: FE Analytics
“I don’t think the risk of a policy error has increased but the Fed has become increasingly confident that the economy is in good shape and therefore can normalise rates,” he explained.
“It’s important to understand they are normalising rates not tightening with a view to ending the business cycle expansion because inflation is simply not an issue at the moment.”
Whatever level the Fed decides is the neutral rate is a moot point, according to Greenwood, the outcome will remain the same: rates will rise.
“Rates will certainly rise probably another four hikes from where we are at the moment,” he explained. “I think they will be spread out over the next 18-24 months and the analogy one should draw is with the mid-course correction that we saw in 1994-1995 and 2004-2005.
“This is not raising rates to squeeze the economy, it’s just getting back to normal levels so the economy can continue to grow with decent growth and low inflation for several more years.”
Effective Federal Funds Rate
Source: St Louis Federal Reserve
Greenwood also wrote off concerns over the burgeoning US-China trade war, which he said is unlikely to have as big an impact as people think.
“The important point to keep in mind always is that what really matters for countries is the state of domestic demand,” he said. “The mistake that people make is to associate tariffs like the Smoot-Hawley tariffs in 1930 with the Great Depression.
“The Great Depression was caused by the contraction of domestic demand and the tariffs were periphery to it.”
Indeed, Greenwood highlighted the Fed’s role in ensuring that domestic spending continues growing at rates in-line with inflation targets.
For the US, the impact of tariffs on GDP is likely to extend to “fractions of a per cent” while it was likely to affect Chinese growth by 1-1.5 per cent.
Despite having a greater impact on China, however, the Asian powerhouse will remain in good shape. The Invesco chief economist said tariffs imposed by the US president are only in the 10-15 per cent range and unlikely to have a great impact.
A more pressing concern for Chinese authorities are the country’s debt levels, which Greenwood said they have taken steps to address.
The economy racked-up large levels of debt in the high growth period between 2008 and 2016, following the global financial crisis and as the shadow banking system grew.
As such, the process of deleveraging is now a key policy of Chinese authorities, according to Greenwood. At the same time, however, some key segments of the economy have weakened leading authorities to lower interest rates and reduce reserve requirement ratios.
“But we’re not seeing credit and money growth accelerating, so the demand for credit is weaker,” said the economist.
“It’s not creating a new problem of rapid credit growth, so I think China will continue to grow at something like 6 per cent but I don’t think it’s problems of indebtedness will grow quicker.”
China debt-to-GDP over 20yrs
Source: Institute of International Finance
Indeed, the debt issues that have plagued other emerging markets are unlikely to affect China, said Greenwood.
“In emerging markets we’ve seen some countries build up debt quite rapidly and others have got into trouble,” he explained. “But I would distinguish strongly between countries like China and Korea – on the one hand with high debt levels but that are controlling domestic spending – with countries like Argentina and Turkey, which have had very rapid growth of credit and have got into trouble as a result of that.”
Greenwood said Argentina and Turkey had “largely created their own problems” through high levels of credit growth in recent years.
“It’s not due to rising Fed rates or a stronger dollar, they’ve created their own problems,” he added. “The possibility of contagion is limited to those countries that are perceived to be in the same boat.”
However, he noted that all countries are dealing with the impact of a stronger dollar and rising rates and that a repeat of the Asian financial crisis of the late 1990s – or any type of contagion – was unlikely to be repeated given the robustness of balance sheets in the region.
“As long as the US continues to maintain domestic demand growth at a good rate then I don’t think, globally, we’re going to go into major downturn,” he concluded.