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Inflation and Markets

Overview: The greatest puzzle currently troubling economists is how the exceptionally low, and steadily falling US unemployment rate has not lead to a sustained lift in inflation. In fact several economists are calling the Phillips Curve, the historical inverse relationship between the unemployment rate and inflation, dead. This is a critical issue because of the importance of US inflation to global financial markets, not just through the influence on the US Federal Reserve (Fed), the most watched and powerful central bank, but also by its impact on global inflation expectations. Since the GFC recession, US growth has been muddling along, with the range between low and high growth a narrow 1.4% - a low of 1.3% growth in 2012 and a high of 2.7% growth in 2010. Inflation on the other hand has seen around twice the range as growth, with a low of 0.5% in 2015 and a high of 3.3% in 2011. This has been more extreme recently, with growth stuck around 2% over the last two calendar years, with a range of 0.2%, while inflation has been quite variable, with a range of 1.3%. At each point at the extremes in the inflation range, markets have extrapolated the outcome as the future trend, seeing wild swings in inflation expectations and disappointment when inflation moved back into the range. Recently, we have seen the powerful effect changes of inflation expectations can have on financial markets – deflation fears in 2015 hit markets for six, reflation in 2016 saw a strong recovery, and lack of follow through on reflation in 2017 seeing volatility collapse – not just at a broader market level but also on a sector level. In this note we will explore the likely direction of inflation and inflation expectations and the impact this will have on financial markets.

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