INSIGHTS

On September 25, 2017

AAM Viewpoints – Inflation and Interest Rates

As markets expected, the Federal Reserve left interest rates unchanged in their September meeting. However, inflation is still running below their target and Fed chair Janet Yellen described it as something of a “mystery.” Even though the job market has picked up, the Fed has been unable to identify the reason inflation remains stubbornly low and chair Yellen announced the Fed reduced its outlook for inflation, cutting its expectation from 1.7% to 1.5% this year and doesn’t expect 2% until 2019.

A crucial responsibility of any central bank is to control inflation. I believe we will see inflation trend higher even though the Fed has undershot its inflation target of 2%, as measured by the Personal Consumption Expenditures (PCE), since 2012 when it established the level of inflation as one of its policy goals. Since 2009, headline inflation has averaged 1.5% and core inflation (which does not include food and energy) has average 1.3%. The PCE inflation rate has been below the target since April 2012.

History tells us falling unemployment should drive wages and inflation higher, but higher inflation has not materialized despite the synchronized global expansion and tight labor markets. As Fed officials try to make sense of how low unemployment persists with low inflation, they believe that inflation will slowly rise next year as labor demand lifts wages and higher wages lead to rising prices. This belief has contributed to two interest rate increases this year with the current odds of another rate increase in December of this year at 63% and potentially three more increases in 2018.

Even though inflation data has been muted, this environment is one where economic growth is on an accelerated path compared to the average GDP growth rate of 2.1% since the end of The Great Recession. Corporate earnings have been increasing in the last year and the unemployment rate is not just low in its headline numbers, but showing the possible signs of wage inflation. Below I’ve highlighted a few factors that suggest inflation could trend higher.

National Federation of Individual Business (NFIB)

The small business outlook is at levels not seen since 2005 and the data may point to higher wage inflation in the future based on the quality of labor and the need to keep or attract the employees they need. The current level of optimism hasn’t been seen in over 10 years when wage inflation averaged 3.9% versus the long-term average of 3%. Higher wages should contribute to higher prices.

Source: NFIB Small Business Economic Trends

NFIB current job openings are at 15-year highs.

Source: NFIB Small Business Economic Trends

Capital expenditures continue to move up and point to an improving economy and higher inflation.

Source: NFIB Small Business Economic Trends

National Association of Purchasing Managers (NAPM) - ISM Manufacturing

Economic activity in the manufacturing sector expanded in August as the economy grew for the 99^th consecutive month as the Institute for Supply Management (ISM) index reached 58.8 which is the highest reading since April 2011. The Prices Index component registered 62% in August, the same as July, indicating higher raw materials’ prices for the 18^th consecutive month.

Source: Institute for Supply Management

The Big Unwind

The Fed provided a timetable for the rolling off its $4.5 trillion bond portfolio. Beginning in October 2018, the Fed will allow $10 billion to roll off at first, increasing quarterly in $10 billion increments until the total hits $50 billion. The risk is that the Quantitative Easing (QE) unwind could inundate the market and as new supply comes into the market without the Fed on the other side, that can push prices down and yields up. Remember, interest rates and inflation move in the same direction. The chart below references an 18-month global central bank asset projections for the United States, U.K., Eurozone, Japan and Sweden from Goldman Sachs Asset Management (GSAM).

There are many factors that contribute to higher inflation and these are only a few. You must also consider one-time events that impact the economy – such as hurricanes. The initial effects of Hurricane Harvey held down housing starts and completions and pushed up cross-border imported energy prices and the effects of Hurricane Irma have yet to appear in the economic data. When evaluating the trend in inflation, we suggest you “don’t fight the Fed” and remember central banks around the globe are trying to generate inflation. The trend will likely be to higher inflation and higher interest rates. Since we don’t know the speed of the movement, we believe it’s probably better to be invested defensively than not be invested at all.