Increasing Inflation Expectations


By: Jeremy Office P.h.D, CFP, CIMA, MBA Special to the Boca and Delray newspapers
After years of deflationary fears, despite the repeated efforts of central bank policies, we have started to see inflation concerns appear in the headlines. With the elections behind us, we are now focusing on the economic policies of the incoming president and how that might affect central bank policies. One metric that has been under the microscope is inflation. Inflation is defined as a sustained increase in the general level of prices for goods and services. In the simplest form, increasing inflation means it costs more to purchase a box of cereal today, than it did last month. When conducting monetary policy, central banks use inflation gauges such as the consumer price index (CPI) or the personal consumption expenditures price index (PCE) as barometers to monitor economic health and ultimately influence their decision to expand or contract the money supply.
In 1974, economist Herbert Stein, a top advisor to President Nixon, called inflation a “Hydra-headed monster” that came in numerous forms: “sometimes led by wages, sometimes by prices, by foods, by oil; sometimes it was domestic and sometimes imported.” The idea was that the more we attempted to tame prices, the more inflation would grow; synonymous to the mythological creature which grows two heads when one is cut off.
In 2007, the Fed’s attempt to control the money supply was soon put to the test. However, when the Fed targeted growth of money supply, the relationship between the growth of money supply and the health of the economy broke down. The Fed then changed gears and pursued an unofficial inflation target for a long period prior to the official announcement of the 2% target in January 2012. As you can see, there is never a right answer and the ability to control inflation is a dynamic balancing act.
More recently, October saw a selloff of bonds as the dollar rose back to where it started this year. This week, after Donald Trump was elected to be the next president, we witnessed another leg lower for bond prices as yields on the 10 year broke through 2% with little resistance from 1.86 the day before the election. While it appears these two moves equate to the expectations of a strengthening economy, the rise in inflation expectations is becoming apparent. Inflation erodes the purchasing power of a bond’s future cash flows. The higher the current rate of inflation and the higher the (expected) future rates of inflation, the higher the yields will rise across the yield curve, as investors will demand this higher yield to compensate for inflation risk.
Per the Wall Street Journal, “the average U.S. inflation rate over the next 10 years priced into bond markets is at its highest level this year. Moreover, one of the best gauges of spare economic capacity, the unemployment rate, has fallen from 10% in 2009 to nearly 5% in 2016, according to economists at Goldman Sachs.
It would be reasonable to presume that the Fed is motivated to raise the federal funds rate in the event of low unemployment and rising inflation nearing the 2% target. But, Fed Chairwoman, Janet Yellen recently spoke about allowing unemployment to drop to levels associated with accelerating inflation to counterbalance the damage from years of joblessness. Even the Bank of Japan announced in September that they plan not only meet their 2% target, but to exceed it. However, pursuing higher inflation rates, as we have seen from Japan and Europe, can become quite problematic. Japan’s and Europe’s zero and negative short term interest rate policy coupled with quantitative easing to bolster lending, growth and prices diminished banks’ lending margins, undermining their ability to lend. Perhaps the Fed will take a lesson from the Bank of Japan and the European Central Bank’s unsuccessful efforts to raise inflation.
To better understand how the Fed reacts to rising inflation, we took a historical perspective on what levels of inflation the Fed typically pursues when anticipating a rate hike. Over the last thirty years, five rate hike cycles have taken place. One common factor preceding each rate hike was an improving macroeconomic environment, mostly evidenced through labor market data. Unemployment steadily declined, non-farm payroll growth was strong, but inflation data suggests no predictable trends. In most tightening cycles, however, inflation either held steady or gradually started to rise after the Fed began hiking rates. It seems apparent that the Fed primarily refers to trends in labor market data when deciding to raise the federal funds rate, while preemptively curbing inflation rather than swiftly reacting to rising inflation pressures. Maybe Stein was correct the whole time.
Compared to the median inflation level (3.2%) in the past 42 years, our current environment is one where inflation is low and rising. Per JP Morgan Asset Management, in a low and rising inflation period, equities have averaged returns of 20% seven times since 1974, surpassing all other asset classes. Commodities stood in second averaging 17%, while bonds and cash fell short averaging 6% and 3%, respectively. We want to highlight the positive returns of each asset class and let investors know that inflation may be a “hydra headed monster” to economists and central bankers, but to investors inflation is something to prepare for, but not to be feared.
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