Curiosity is defined as a strong desire to know or learn something. It is also defined as a strange or unusual object or fact. Curiosity is an important trait for investors. Along those lines, your authors are curious about this particular curiosity: Where is inflation?
Before proceeding we will offer these disclaimers: 1) we are not, nor do we aspire to be, economists; 2) economics is a “soft science,” at best. Economists collect, measure and analyze data in an effort to provide understanding of human behavior as it pertains to the production, distribution, and consumption of goods and services of individuals (microeconomics) and the economy as a whole (macroeconomics). A core of human behavior is precisely why economics cannot be classified as science. Moving on…
Forecasting inflation is very important to macroeconomics. Price stability, defined as the avoidance of prolonged inflation (or deflation) is, after all, one of the statutory mandates of the Federal Reserve Bank (“Fed”). Price stability preserves the purchasing power of money.
Why do we care? Inflation (or lack of) is an important consideration in investing and portfolio management. Inflation erodes “real” (net of inflation) returns on all assets and real savings. Historically, stocks have provided a most meaningful hedge against moderate rises in inflation, but not during times of inflationary shocks, like the 1970s Energy Crisis. Taxable, fixed-rate bonds underperform during inflationary periods as inflation erodes the value of the bonds’ principal. Inflation readings and their implications and inflationary forecasts are things we think about.
There are a number of ways to measure inflation in an economy. The Consumer Price Index (“CPI”), which measures the average change over time in prices paid by urban consumers for a market basket of goods and services, is the measure that is most well-known. Also, CPI is used to adjust Social Security payments. The Personal Consumption Expenditures (“PCE”), broadly similar to the CPI, is the Fed’s preferred inflation measure. For both the CPI and PCE there are“headline” and “core” measures. Core measures strip out the more volatile food and energy components.
Take a look at the chart below. The blue line represents Core PCE. The green line represents the Fed Funds rate, which is a short-term (overnight) interest rate set by the Fed to control the supply of money and, hence, interest rates and inflation. The shaded areas indicate US recessions.
Rampant inflation during the late 1970s spurred the Fed, led by Chairman Paul Volcker, to drastically hike the Fed Funds rate in order to break the back of inflation. He succeeded, and inflation has been on a downward trajectory ever since.
Fast forward to the end of 2007 and we see how the Fed cut the Fed Funds rate to effectively 0% in response to the Credit Crisis and deflationary fears and held it there until 2016.
There are a number of factors that influence inflation. These can be categorized as either “demand-pull” or “cost-push.” Demand-pull factors, such as expansionary monetary and fiscal policy stimulus, increase the money supply and, thereby, create greater demand for goods and services. Cost-push factors, such as higher wages and raw material costs, push prices higher.
Consider the environment we’ve been in:
- The Fed injected massive monetary policy stimulus through both “Quantitative Easing” and 0% (Fed Funds) interest rates over an extended period of time, thereby increasing the Money Supply. Inflationary.
- The US Government has used the low-interest rate environment to finance perpetual budget deficits and refinance outstanding debt. From 2007 through today, Federal debt outstanding has increased from $9.2 trillion, 59% of Gross Domestic Product (“GDP”), to $22 trillion, around 115% of GDP. Inflationary.
- Abnormally low interest rates have fueled an increase in debt leverage by corporations to finance takeovers and stock buybacks which, in turn, has inflated asset prices. Inflationary.
- More recently, in 2017, President Trump approved new fiscal stimulus in the form of the tax cuts. Inflationary.
- Today, unemployment is at 3.6%, the lowest reading since 1969, and wage growth is on the rise. Inflationary.
- Should trade talks between the US and China fail and higher tariffs result, the impact would be…inflationary.To summarize, we have been in a prolonged period of low interest rates, high leverage, high asset price multiples, large fiscal deficits and generationally low unemployment. Curiously, the Fed’s core inflation measure remains stuck below their target of 2%. Hmmm!Please call us at 318-675-0826 if you have any questions.
Jack E. Ditt, Jr. William L. McCollum