We are now witnessing a long-overdue asset repricing to reflect rising inflation expectations in an economy driven by excessive fiscal and monetary stimulation.div > div.group > p:first-child">
Wage increases may be a more vivid event, but the last month"s 2.9 percent annual increase in hourly compensations that sunk the markets was nothing new. Wages and salaries rose 2.8 percent in the year to the fourth quarter, and, for all of 2017, they marked a steady annual growth of 2.6 to 2.8 percent.
Those of you who still look at wages may wish to think of this: Wages don"t cause inflation, unit labor costs do. If a wage increase is substantially offset by rising labor productivity, costs per unit of output could remain stable, or of no particular consequence for corporate profit margins.
However, if the productivity growth falls short and production costs shoot up, businesses will raise prices to protect profits and investment returns. Such price hikes will stick under conditions of a growing economy, and will lead to rising levels of the general price inflation. Increasing wage claims will follow, triggering a wage-price spiral you probably heard about in your economics lectures.
What comes next is a nightmare: Only the Fed can break up that spiral by throwing the economy into a prolonged slowdown, recession or worse.
Now, please keep that classic wage-price mechanism in mind as we get back to the real world, where President Donald Trump says that declining asset markets are making a "big mistake" because "we have so much good (great) news about the economy!"
Here is why that news may not be as great as he thinks.
The physical limits to America"s economic growth are currently estimated in the range of 1.5 to 1.7 percent. Those limits are set by the stock and quality of human and physical capital. And that particular growth rate that the effective supply of labor and physical plant can allow — without causing accelerating inflation — is called the economy"s growth potential, or the noninflationary economic growth.
The actual growth rate of 2.3 percent observed last year exceeds the noninflationary growth potential by nearly an entire percentage point. One should also note that the economy"s pace of advance accelerated during last year from 2 percent in the first quarter to 2.5 percent in the fourth quarter.
Predictably, those strengthening growth dynamics led to an increasing labor demand and a pickup of labor compensations (wages, salaries and benefits) in the private industry from 2.3 percent in the first quarter to 2.6 percent in the last three months of 2017.
To sum up: At the beginning of this year, we have rising capacity pressures in an economy growing above its noninflationary growth potential and steadily increasing labor compensations. (We can only hope that the last year"s 1.3 percent increase in labor productivity will continue in the months ahead to offset some of the costs of rising nominal labor incomes.)
That"s frightening the markets. They now see an economy pushing well above its physical limits to growth being turbo-charged with a huge fiscal stimulus — tax cuts plus increasing public spending — and extraordinarily large and cheap credit flows.
The "good (great) news" that Trump is talking about is an economy choking on rising demand pressures that are spilling into record-high trade deficits as the Chinese and the Europeans keep rushing in to supply the goods and services America cannot produce at home.
Those demand leakages drove up the last year"s trade deficit by 7.7 percent to $810 billion — an event that should infuriate the president who promised to stop, and reverse, such a worsening decades-old trend. And, in view of the president"s past rhetoric, it seems particularly galling that China"s $375 billion surplus (an 8.1 percent increase from 2016) accounts for nearly half of America"s widening trade gap.
Markets don"t need perfect foresight to see that the growing excess demand coming down the pike will inexorably lead to rising inflation and increasing budget and trade deficits. They also know that an avalanche of American public debt issues will follow.
Now, please note: That is not a one-off event; that is a process of changing growth, inflation and deficit dynamics driven by an explosive policy mix.
With that in mind, those expecting a quick return to steadily rising asset values may wish to think again.
Indeed, the Fed"s long hesitation waltz must now give way to an accelerating pace of policy restraint to "normalize" the credit stance, and to balance out the policy mix in response to a strong fiscal easing.
So far, the Fed has done virtually nothing. During the three months to January, the Fed"s monetary base (the right-hand side of its balance sheet) was trendless. Over the 12 months to January, that monetary aggregate — the only one that the Fed directly controls — expanded by $293.2 billion, showing an annual growth rate of 6.4 percent. Similarly, excess reserves (loanable funds) in the banking system at the end of last month were still a huge $2.1 trillion, or 4.5 percent more than a year earlier.
Meanwhile, the effective federal funds rate — the Fed"s key policy instrument — remained stable at 1.41 percent (well below the 1.50 percent target) since mid-December, while, over that period, the yield on the benchmark Treasury"s 10-year note rose 39 basis points, finishing the last Friday"s trading session at 2.85 percent.
That sharply steepening yield curve is telling the Fed to get going — presto.
A friend told me some time ago that the library at the Trump Hotel on New York"s Central Park West has a framed quote of the English poet William Blake hanging on the wall: "You never know what is enough until you know what is more than enough."
One can appreciate that Trump wanted to deliver on his electoral promise of tax cuts that would rev up the economy from a lethargic growth rate of 1.5 percent during the election year 2016. He fought hard to deliver, and he did.
But the other side of the coin is that the huge fiscal stimulus of Trump"s sweeping tax reform will be coming on stream at the time when an extraordinary credit creation is driving the economy well above its potential and noninflationary growth rate.
And there is the problem: An excessive stimulation of economic activity is stoking inflation expectations, pushing up bond yields and signaling a long process of monetary tightening. That is a tough job, where the Fed"s visual navigation has to lead to an economic growth recession.
The initial stage of that process causes sharp price losses on fixed-income assets and takes some froth out of the equity values. That impact is reversed as the economic slowdown begins to take hold and a recession outlook becomes the main trading scenario.
My preference is still for solid equity investments — or what people usually call defensive stocks that will resist the unfolding bear market.
As a consolation perhaps, Trump apparently has one more of Blake"s aphorisms framed on that same library wall: "The road of excess leads to the palace of wisdom."
This might be the piece of wisdom we need: Increase the stock and quality of labor supply by bringing back into the market millions of Americans with accessible education, health care and vocational training. Businesses will then respond to the brightening sales outlook with investments to outfit labor with best-practice technologies. That could make it possible to go back to America"s noninflationary growth potential of 3 to 3.5 percent last seen in the 1990s.
Commentary by Michael Ivanovitch, an independent analyst focusing on world economy, geopolitics and investment strategy. He served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York, and taught economics at Columbia Business School.
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