The Independent Market Observer

2/27/14 – The Future of Inflation

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Feb 27, 2014 11:58:46 AM

and tagged Commentary

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I was meeting with our asset management group this morning, and one of the topics of discussion was a strategy that hedges against inflation using swaps instead of TIPs. This is a fairly esoteric topic, certainly more so than I normally cover here, but it got me thinking about where inflation might be going and why. Is now the time to start thinking about this risk?

Thinking, yes; doing, probably not. The reason is that inflation remains subdued in many areas, and although it’s certainly appropriate to plan for it, the time to act probably isn’t just yet.

To see why, let’s examine the actual structure of inflation. If we look at the components of the Consumer Price Index, we see that housing is the largest piece, followed by transportation and food and beverages. Together, these categories cover almost three-quarters of the index.



Housing rents, which are surveyed directly, are therefore an indicator of where inflation is heading. If we look at residential rent trends, we see that they’ve been around 4 percent on an annual basis—suggesting that this large component will act to pull inflation upward.


We can see this directly in the following chart. (Note the recent uptick.)


Clearly, this is a leading indicator that suggests higher inflation.

Other major components are transportation and food and beverages, which both show the opposite. For transportation, inflation doesn’t actually seem to be an issue, per the following chart.


Prices have actually been pretty flat over the past year or so, heading down more recently. This will at least partially offset the rising housing costs.

Food and beverage inflation is flat to down as well, which will also offset housing.


The other components—medical care, education, and recreation—show a similar picture. Medical care has been around 2 percent, although a recent bounce up suggests this is worth watching. Education has shown spikes, but the height of those spikes is decreasing. Recreation is very similar to medical care.

Overall, and with the exception of housing, no inflationary pressures are apparent. In the short term, inflation does not appear to be a real worry, and this has been borne out by the data.

When will this change?

There are two things we have to watch for. One is wage growth acceleration—which hasn’t happened yet, per the following chart, but which many economists expect later in the year as the unemployment rate continues to decline.


The second is an acceleration in lending, which will raise the velocity of money. Here again, we haven’t actually seen an increase but a decline.


The balance of the data, then, suggests that inflation is not a current problem. The time to fix the roof is before it rains, though, and that’s why we will be looking at those swaps, just so we know about them when the time comes to adjust the portfolios for inflation.

That might not be soon.

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