The apparent consensus among investors seems to be that inflation will never be an issue again. 30 year Treasury note yields, a common proxy for inflation expectations, are nearly as low the stock market crash in 2008-09. Yet, unemployment has just dipped below 5% in the U.S. and wage gains are starting to trend above the average of the last few years. Since the unemployment rate has dropped so low, it is possible that the acceleration of wages could increase exponentially as there a fewer workers to draw from, thereby accelerating inflation pressure.
Further, I think investors are overlooking some important data which suggests inflation is starting to increase. The headline number is often cited, and with oil prices crumbling, these numbers are below 1%. However, if you look closer at the “Core” numbers which exclude Food and Energy, the latest CPI read in Dec 2015 was 2.1%. I have taken it a step further and isolated “Services excluding Energy”. This is particularly useful, because close to 70% of GDP comes from consumer spending. Of that spending, 67% comes from services rather than goods. Service spending is the leading contributor to GDP in the United States. So how are those prices moving?
Clearly, these prices are starting to trend up in 2015, pulling away from an average of 2.5% over the last few years. I think this demonstrates that the additional cash people are receiving from low gas prices and the green shoots of higher wages are allowing service companies to increase their prices. As I have mentioned, Saudi Arabia appears ready to keep oil prices low, and the labor market continues to remain strong. Consensus forecasts are for unemployment to continue its decline in 2016. Therefore, both of these influences on inflation should continue.
But what does this really mean? A continued rise in prices should alleviate any fears of deflation, which has been a major concern for the Fed since the Housing Crisis. The level of increases point to a healthy economy that is able to sustain a normalization of interest rates. The fact that the Fed has went ahead and started the path back to normal rates in December is encouraging. This policy tool (of lowering rates) has been very effective when our economy has ran into bumps in the road and needed stimulus. By keeping rates at the 0 bound, we have fewer tools to help in times of need. So I think the Fed is doing the right thing and should continue with their plans for small, continuous increases. In my opinion, the risks lie in the bond market. If the pressures I have highlighted continue to increase, at some point, investors will wake up to these realities and reprice accordingly.
– Charles F. Freeman, CFA