Inflation: A Market Update
Since the subprime recession of 2008, inflation in the U.S., and abroad, has stayed remarkably low. Indeed, a mixture of muted economic growth, low wage growth and declining commodity prices have served to keep a lid on inflationary pressures. The most recent core Consumer Price Index (“CPI”) reading for December registered annual inflation at a rate of 2.2%. While core CPI remains relatively tame compared to historical readings, current numbers suggest that inflation is, in fact, rising.
To be clear, some modest level of inflation is actually a good thing. What the U.S. Federal Reserve has tried to avoid at all costs is the specter of deflation, like what we have seen over the past decade in Japan. When an economy experiences deflation, goods and services become cheaper in the future. This phenomenon encourages consumers to save their money for later, and not to spend it. Long-term, deflation actually creates the conditions for severe recession.
Fed Chair Janet Yellen and the Fed will attempt to create an environment in the U.S. of modest, but not high, inflation. This so-called “Goldilocks” level of inflation will be high enough to encourage consumer spending and economic growth, while remaining low enough that it does not overly impact purchasing power and borrowing costs.
The Fed has indicated that it is targeting a long-term inflation rate of 2% for the PCE, a statistic otherwise known as the Personal Consumption Expenditures Index. As of the latest reading, the PCE stands at about 1.6% annualized. So we are still slightly below the Fed’s goal. Still, it appears that we are approaching the 2% inflation target fairly quickly.
Perhaps the largest impact that rising inflation will have is a boost to bond yields. Should we experience unexpectedly high inflation in the coming months, the Federal Reserve would likely lift short term interest rates in response. Additionally, longer term bonds would also likely see their yields rise. Accordingly, we have remained “underweight” longer bonds in our investment portfolios in expectation of these potentially rising rates.
A paradigm shift regarding inflation is likely soon to arrive. While we have welcomed increased inflation since 2008 as a sign of economic growth and improvement, we now approach an inflation level where it is no longer an unqualified good thing. Looking ahead, financial markets will greet rising inflation with more caution. In the meantime, we remain vigilant in hedging out bond exposures.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.