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Mihir P. Worah
With the recent unexpected boost in U.S. consumer prices, many are wondering whether the economy has reached a turning point for inflation. Could rising inflation challenge the Federal Reserve’s resolve for continued accommodative monetary policy?
The Fed has made some progress toward its employment mandate, with unemployment down to 6.1% from the post-crisis peak of 10%. However, it continues to miss its inflation mandate – a target of 2% on the Personal Consumption Expenditures (PCE) price index – as the core rate has remained below target for almost six years now, except for a brief period in Q1 2012. This, along with the employment shortfall, has meant that the Fed’s two main goals of maximum employment and stable prices both warranted a highly accommodative monetary policy. And it provided this via both low rate guidance and maintaining (and increasing) a large balance sheet.
We believe the modest rise in inflation is generally a welcome development for the Fed because it reduces the risk of too-slow inflation or even deflation. Markets, however, should not extrapolate the current high monthly pace of Consumer Price Index (CPI) increases into the future.
While the current pace may not accelerate much in the short term, longer-maturity TIPS (Treasury Inflation-Protected Securities) are not pricing in much of an inflation risk premium, if at all, and we see them as attractive investments.
Inflation’s path so farWe focus primarily on CPI (and core CPI, which excludes food and energy) when analyzing the TIPS market. The CPI is the more widely recognized price measure, and it is released every month before the PCE, so it has more market relevance and it is the index to which TIPS and inflation swap cash flows are tied. The CPI is generally about 0.3% higher than the PCE index due to its calculation, composition and scope, though it is currently running at a rate slightly above that. We also touch upon the PCE given it is the focus of Fed policy.
The last three CPI releases have been much stronger than market expectations, with the last print being the highest core month-on-month print in almost five years, taking the year-over-year (YoY) core CPI rate to 2%, a level not seen since February 2013 (Figure 1). The headline CPI is now at 2.1% YoY, a level not seen since October 2012.
Early this year, we forecast a reasonably strong pickup in inflation (see “U.S. Inflation Outlook 2014: Signs of Life,” January 2014) that would bring core CPI to 2.1% by the end of 2014. While our scenario has largely played out, we do not expect a continued steep rise in the inflation rate. We believed that shelter inflation, which at 32% makes it the largest component of the CPI, was poised to accelerate to a 3% YoY rate in 2014. May’s CPI data already showed shelter inflation up at a 2.85% annualized pace.
We also wrote about the abating disinflationary influences of food and energy. Both prices bounced back strongly to 2.25%–2.5% YoY in the CPI, with gasoline prices more recently getting further support from tensions in Iraq.
The lagged effects of a bounce in the Chinese CPI also supported goods inflation, and the continued reduction of domestic slack was a positive for service-sector inflation more broadly.
What lies aheadWhile we expect a continued pickup in the pace of core inflation, we think it will be gradual. The stalling of home price appreciation, the stabilization of vacancy rates and falling mortgage rates all suggest that shelter inflation should not rise much beyond 3% YoY.
Recent high readings of food inflation should be tempered going forward as grain prices have fully reversed prior gains and stocks are plentiful. While oil and gasoline prices are near their highs, futures prices point to a marked deceleration in the coming year. In particular, further rises in oil will depend on whether the Islamic State of Iraq and Syria (ISIS) captures the oil-producing region in Southern Iraq, around Baghdad. We think this is unlikely.
The headline unemployment rate continues to drop, but as Fed Chair Janet Yellen has consistently alluded to, there remains a large pool of shadow unemployed that will continue to keep labor bargaining power in check.
Overall, we expect core CPI to reach 2.3% in mid-2015, with headline CPI at similar levels. The TIPS market, which just a few months ago was pricing inflation well below 2.0% over this period, has largely come around to this view, as seen from the appreciation and current pricing of short-maturity TIPS. However, longer-maturity TIPS have not reacted as positively and continue to price in U.S. inflation largely at the Fed target (2% PCE + 30 basis points = 2.3% CPI). So there is little, if any, long-term inflation risk premium priced into the market (Figure 2).
Given a Fed that clearly desires inflation higher than current rates, we believe longer-maturity TIPS should be pricing in higher inflation rates. As such, we think longer-maturity TIPS should be a core fixed income holding in portfolios.
An eye-opening press conferenceAfter the Fed meeting, Janet Yellen was dismissive of recent high CPI readings, acknowledging that the data has been on the high side but also saying that it is noisy. Additionally, she said that inflation is evolving broadly in line with FOMC projections. This makes sense, since the core PCE index is still at just 1.5% YoY, 50 basis points below the 2% target. While we largely agree with her assessment that the recent pace of inflation readings is unlikely to be sustained, for a Fed Chair not to sound even a bit vigilant as to the risks of higher inflation is very dovish indeed.
Yellen also said she expects to see nominal wage growth pick up (faster than the pace of inflation) as the labor market tightens and labor is able to garner a bigger share of the GDP pie. She would welcome such a development “within limits,” as real wage growth will at least rise in line with productivity, which it has lagged for quite some time. We wholeheartedly support this approach since it continues to nurture the economic recovery, but should the Fed miscalculate in terms of slack in the labor and product markets, inflationary risks could come to the fore.
Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. Investors should consult their investment professional prior to making an investment decision.
The Consumer Price Index (CPI) is an unmanaged index representing the rate of inflation of the U.S. consumer prices as determined by the U.S. Department of Labor Statistics. There can be no guarantee that the CPI or other indexes will reflect the exact level of inflation at any given time. The Personal Consumption Expenditures (PCE) deflator is published by the Bureau of Economic Analysis as part of the GDP report. It measures inflation across the basket of goods purchased by households, and is computed by taking the difference between current dollar PCE and chained dollar PCE.
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