With high and rising levels of debt to GDP, unconventional monetary policy and the risk of commodity price spikes, the U.S. is clearly facing longer term risks for higher inflation. In fact, we continue to believe inflation will be higher on average even over the next several years than it has been over the past 15-20 years. And some may wonder: “Why isn’t inflation higher today?”
Inflation initially moved down following the 2008 credit crisis due to excessive spare capacity in the economy. However, core inflation, which excludes the volatile food and energy components and is what the Federal Reserve tracks for policy purposes, is currently running at roughly 2% per year, which is essentially what it averaged over the decade prior to the credit crisis (see Figure 1).
Some attribute this increase to inflation expectations being anchored around 2% and the success of the Fed’s inflation targeting efforts. However, we believe it could be symptomatic of deeper issues. So we think a better question is: “Why is inflation so high amid elevated levels of unemployment, tight access to credit for households and the ongoing deleveraging?”
Inflation vs. unemployment
When it comes to forecasting and understanding inflation over the medium and longer term, we believe it is helpful to use a top-down, macroeconomic-based inflation model. The most common and simplest, the Phillips curve, relates inflation to the slack in the labor market. The Phillips curve says that as unemployment increases, the rate of inflation should fall because excess spare capacity pushes wages down and results in lower demand for goods. However, over the last two years forecasted inflation based on the unemployment rate has markedly diverged from actual inflation (see Figure 2)
We believe this is the result of inflation expectations moving higher, a consequence of the Fed’s policies of balance sheet expansion and financial repression. Given the increase in inflation expectations, we believe that in the future, inflation will run higher for a given level of unemployment than it has over the past several years. Thus, as the Fed pursues its dual mandate of full employment and price stability, it will have to make a choice: let inflation run above target for some period of time, or become less accommodative. Based on what we have seen to date, we believe the former is more likely.
Core inflation breakdownbr />
To get a more complete picture, we can also look at a more bottom-up approach. Shelter is the biggest component of core inflation, at 41% of core CPI. It’s also relatively slow moving and tends to exhibit strong trending behavior. Based on our analysis, we believe that changes in shelter inflation largely depend on three main factors: the vacancy rate in the rental market, home prices and mortgage payments (see Figure 3). Historically, changes in these factors have accurately predicted future shelter inflation with a lead time of 12-18 months.
Using this framework, we believe that shelter inflation will be relatively steady at near 2% through 2013. While it is true that lower vacancy rates and an improving housing market are providing upward pressure to rental inflation, housing prices didn’t really bottom until Q2 2012, which means we don’t see that pressure materializing until near the end of 2013. In addition, the declining interest rates and lower mortgage payments have also helped keep shelter inflation in check. However, with rates near zero and home prices starting to rise, we believe mortgage payments have effectively bottomed out and only have one way to go. We expect higher shelter inflation to start to materialize in 2014 as the impact of mortgage payments moves back to neutral and housing prices start to pick up (see Figure 4)
Beyond shelter, we also expect the rest of the components that make up core CPI to be relatively steady in aggregate. While inflation will likely rise in certain sectors, such as used cars, it will likely be offset by others, such as consumer goods. Adding it all up, we see core inflation at or slightly below 2% during 2013. Headline inflation, which contains the volatile food and energy components, will likely feel modest upward pressure from food inflation due to the severe drought in 2012. However, in aggregate we believe it will generally be in the range of 1.75% to 2.5%. This means those of us waiting for inflation to move higher over a secular horizon (three to five years) will likely need to wait until 2014.
The tail risks
Even though we expect inflation to be well contained over the next year, investors should not be complacent.
An oil supply shock due to geopolitical tensions in the Middle East could cause headline inflation to soar well above 2.5%. Longer term inflationary risks are also rising. Imagine learning back in 2007 that unemployment would rise from 4.5% to 8% in five years but that the rate of inflation would basically stay the same. And that the ratio of government debt to GDP would rise from 65% to 100%.
Historically, double-digit spikes to inflation have tended to follow periods of high debt to GDP, unconventional monetary policy and commodity price spikes. For example, inflation spiked after WWI and WWII due to high debt burdens. The inflation of the 1970s and 1980s followed the end of direct convertibility to gold in 1971 and the Arab oil embargo in 1973. Given the current geopolitical pressures in the Middle East, it certainly seems a commodity-led price spike is a non-trivial risk today. And while we are not yet at a 1971 moment in terms of fiat currency devaluation, the recent events in Japan and the movements in the yen should keep us on alert.
In our opinion, a key risk right now is that inflation expectations have moved higher, coincident with the acknowledgment of all these factors.
It all comes down to timing. While we don’t expect inflation to move in the short term, we suggest investors look at the sensitivity of their overall portfolios and ask whether their portfolio positioning is consistent with their inflation expectations. Many investors may be underinvested in inflation-sensitive assets and overinvested in assets such as equities that tend to be vulnerable to inflation, especially if it accelerates above 5%. So the question should be: “Is now the right time to incorporate inflation-hedging strategies?” To answer this, we need to know how much of all this the market has already priced in.
We believe the answer is that the market hasn’t priced in these risks much at all. In fact, inflation has rarely realized below the current level of breakeven inflation priced by the TIPS (Treasury Inflation Protected Securities) market (see Figure 5). Therefore, now may be an ideal time to consider increasing exposure to inflation-sensitive assets like TIPS, as well as other assets that can act as a potential hedge against inflation, such as REITs, commodities and foreign currencies.