Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.
We doubt it. But, price levels are likely to rise gradually in the months ahead, as the rebound in energy commodities continues to impact measurements.
Recent inflation data releases have raised concerns about a potential spike, with headlines warning that the consumer price index (CPI) posted its largest monthly gain in four years. Concerns appear even more acute in the context of recent price level changes. Just two years ago the annual change in CPI was -0.2%; in contrast, last month’s change was 2.5%. Beyond CPI, survey-based and market-based measures of inflation expectations, such as the Survey of Professional Forecasters and the ten-year breakeven inflation rate, also now mostly point to a faster pickup in prices relative to the signals indicated last year.
However, recent increases are exaggerating the level of inflation risk. A little less than two years ago, the CPI’s energy commodity index began a precipitous fall, fueling a disinflationary shock to the global financial system. With the strong rebound in energy prices since early 2016, year-over-year comparisons are relative to low levels, giving the energy commodity index an outsized impact on the headline inflation rate. In fact, energy commodities contributed 0.7 percentage point to the 2.5% increase, despite making up just 3.5% of the total basket of consumer goods. If energy prices hold firm, the impact on the inflation rate will be even larger in the next two readings before tapering off.
Core inflation measurements, which exclude volatile food and energy prices and are thought to be better indicators of future consumer price trends, have been more stable than the headline CPI measure. Annual changes in the core personal consumption expenditures (PCE) price index—the Federal Reserve’s preferred inflation gauge—have been range bound between 1.6% and 1.8% for the last year. The current core PCE measurement of 1.7% is below the Fed’s longer-run objective, and matches the median rate across the last 20-year period. Although survey-based and market-based measures of inflation expectations have picked up in the last year, as noted earlier, they are coming off very low levels and remain near the bottom of their historical ranges.
This is not to say that there aren’t inflationary pressures. One area worth monitoring in the months ahead is wages, as any added costs to employers would eventually need to flow through to consumer prices. By many measures, the labor market is tight—just this month, the four-week average of new claims for unemployment benefits fell to its lowest level since July 1973. While any further tightening may translate into a pickup in wage gains, as employers vie for the best employees, wage pressures so far have been contained. The Employment Cost Index, the last reading of which indicated costs increased by 2.2% in the last year, has meandered around 2.0% this cycle and remains below its 20-year median level of 3.0%.
Wages—and price levels more generally—would also be impacted by faster-than-expected economic growth. Consensus growth expectations have increased in recent months, if only slightly, as economists looked favorably on the Trump administration’s aim to reform tax policies. While it’s not yet clear what proposals will make it through the legislative process, many—including the much-discussed border adjustment tax—appear poised to be US dollar positive, an outcome that would put downward pressure on imported goods’ prices, balancing some of the proposals’ inflationary aspects.
Should gains in price levels occur despite these limiting factors, the Fed’s recent meeting notes highlight its readiness not only to tighten monetary policy in the near term, but also to be flexible in calibrating the policy rate trajectory to match economic conditions, as most policymakers “continued to see heightened uncertainty regarding the size, composition, and timing of possible changes to fiscal and other government policies, and about their net effects on the economy and inflation over the medium term.” The willingness to respond forcefully, particularly in an age of widening interest rate differentials, should work to cap increases in inflation.
But, forecasting inflation is fiendishly difficult, as my colleague Sean McLaughlin wrote nearly two years ago in this publication, meaning investors looking to protect and grow the real purchasing power of their investment pools should continue to place a premium on diversification.
Kevin Rosenbaum is a Senior Investment Director on Cambridge Associates’ Global Investment Research team.
Originally published on February 28, 2017