Higher inflation is coming—in slow motion. Some fear its arrival, as the sharp market selloff at the start of the year amid spiking bond yields demonstrated. And for good reason: Inflation expectations and interest rates have a ripple effect, and are key to pricing across asset classes.
But despite the earlier bouts of market panic, concerns are overdone for structural reasons. When this sluggish beast finally appears, the impact will be modest.
Expectations remain of only slightly higher levels in price indexes. The Federal Reserve’s favorite inflation gauge, called core personal consumption expenditures, which leaves out volatile energy and food, has averaged just under 1.4% since 2010, the first full year after the Great Recession. “While inflation is turning up, it won’t be sharp, and larger forces will keep a lid on it,” said Rich Sega, chief investment officer for asset manager Conning.
The Fed forecasts PCE core inflation to bump up to 1.9% at the end of this year, from 1.5% in 2017. But the interesting thing is the central bank believes this inflation number will rise only to 2.1% for 2019 and 2010. That finally exceeds the Fed’s 2.0% target, which it has had since 2013, but not by much.
The economists’ consensus forecast for the more widely used consumer price index (CPI), as tabulated by The Wall Street Journal, is only a little bit higher: 2.4% for this year and next, and 2.3% for 2020. (The CPI usually runs 0.2 percentage point or so above the PCE. The two indexes employ different survey methods.)
That’s not a very big jump. Previous warnings of rollicking inflation ahead have proven false, wrote Joseph LaVorgna, chief economist for the Americas at Natixis, the French investment bank, in a research note. “Inflation is likely to remain quiescent.”
The public at large is more pessimistic, expecting prices to move up 2.7% over the next year, a University of Michigan survey finds. That may be an outsized estimate, skewed because a lot of people are exposed to a few vexing inflation pockets, such as housing costs, gasoline prices, and college tuitions.
Regardless, none of these projections offers a picture of rampant inflationary pressures. In fact, the outlook for the next few years is low-lying compared to the last three decades. And it’s like a dream when you look at the harrowing double-digit era of the 1970s. From 2000 through 2007, just before the financial crisis (when inflation readings were extremely low), the CPI averaged 2.8%. In the 1990s, it was 2.9% and in the 1980s, 5.1%.
Why is inflation expected to nudge up, however incrementally? The benefits of the long economic recovery at last are kicking in. Labor markets are tight, which has brought long-delayed upward pressure on wages, and household incomes are rising, especially due to the tax cut that takes effect this year.
The cost of shelter is marching upward due to increased demand and a shortfall of supply, owing to construction cutbacks in the wake of the housing bust. Medical care, long a swamp of spiraling prices, is ever more costly as the population ages. Gasoline is the highest in years, thanks to robust demand as people drive more, plus output limits slapped on by the Organization of the Petroleum Exporting Countries (OPEC) and other major producers like Russia. Restaurant tabs are larger. Apple has no qualms about charging $1,000 for an iPhone X.
Making something more expensive, of course, always has some effect. To investors, the result should be positive with advances for stocks in banks and other financial institutions (inflation translates into escalating interest rates, a boon for their bottom lines) and energy (higher pump prices mean higher profits).
Losers likely will be companies that require big borrowing, like telecoms and utilities, which will pay larger interest rates. Since rising rates bring lower bond prices – they move in opposite directions – the upshot there, said Craig Israelsen, a finance professor at Utah Valley University, is: “Bond funds won’t crunch out equity-like returns like they’ve been doing.” The one type of bond that stands to do well is the Treasury Inflation Protected Security, which tracks the CPI.
Still, it’s notable that inflation isn’t expected to ratchet up much more than a half percentage point or so over the next few years. For every harbinger of burgeoning inflation, there are examples of prices moving in the other direction.
Outside of oil, many industrial commodities were slipping in 2018, perhaps due to a slowdown in China. This year, even before President Donald Trump’s tariffs surfaced, prices for copper, aluminum, and iron ore began to skid. Only lately have some started to bob upward as new sanctions on Russia threaten its output of raw materials, such as palladium and nickel.
True, unforeseen events have a nasty way of confounding the most seemingly rock-solid forecasts: While uncomfortable general price escalations typically is a creeping menace, dramatic events do occur that make for sudden changes, like the 1973 OPEC oil embargo, which ushered in the hyper-inflation of the 1970s.
Large forces today, though, are working to contain the inflationary pressure. They are:
Demography. The baby boom generation is retiring in droves, replaced by younger, lower-paid workers. And as the nation’s average age climbs, consumer spending will flag. “Older people don’t spend as much,” because they already have many of the goods they need, said David Ader, chief macros strategist at Informa Financial Intelligence.
Wages. Low pay continues to bedevil the American workforce. While it has edged up recently, rising 2.7% in each of the last two years, that’s still an anemic pace with unemployment at a very low 4.1%.
Culprits are numerous. Unions, which used to bargain for fat raises, have lost much of their clout. US companies are still sending jobs offshore to cheaper locales, despite President Trump’s opposition. And at home, “productivity has stalled,” said Dave Haviland, managing partner at Beaumont Capital Management. Companies have been reluctant to invest a lot in improving worker output for fear a market wouldn’t exist for it, post-recession—although the new tax break for capital spending and lower general rates for personal taxes may improve the situation.
Raises are mounting for skilled labor, now in short supply. But most of the US workforce is now in the service sector, which doesn’t pay as well as manufacturing, noted John Augustine, CIO of Huntington Private Bank. “That keeps down wage inflation,” he said.
Interest rates. The Fed is hiking short-term rates partly to tamp down inflation. And should inflation ascend more rapidly than most expect, “the Fed will move aggressively” to choke it off, said Steve Chiavarone, portfolio manager for Federated Global Allocation Fund. The central bank in the past has shown that it can be a tenacious inflation fighter if it wants to be.
That said, for the moment, as Informa’s Ader described the economic landscape: “Not a lot of inflationary pressure is out here.”