The Problems of Success: Inflation

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jun 19, 2015 1:50:00 PM

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USeconomy_4I closed yesterday’s post with the thought that, based on positive U.S. economic trends, we should now be planning for the problems of success. Sure enough, the economic data released yesterday highlighted a big one: inflation, with the monthly increase in the Consumer Price Index topping 0.4 percent.

It may not sound like so much, but annualized, that increase puts inflation at more than 5 percent per year. When the Fed’s target rate is 2 percent, anything over twice that level should catch our attention. 

No need for panic, however

The rise in inflation was due almost entirely to an increase in gas prices, which rose more than 10 percent month-on-month. Excluding energy and food, the core inflation rate increased only 0.1 percent for the month and actually dropped a bit, to 1.7 percent, over the preceding year. Clearly, inflation is not an immediate problem. 

But it might become one in the medium term, given how much the data has accelerated recently: 

  • In the past three months, core inflation has jumped to an annual rate of 2.5 percent, per Capital Economics, with increases in gas prices layered on top of that.
  • Service inflation is steady, at around 2.4 percent per year.
  • Shelter inflation was in the same range but was pulled down by one-time factors and will probably move higher in coming months.
Why has inflation remained this low?

One of the key reasons is the strong dollar, which has kept prices of imported goods down. Another major factor has been the slow growth in wages. The most important, over the past several years, has been the relatively weak employment and consumer spending situation. 

All of these factors, among others both short and long term, have combined to keep inflation at very low levels. And all of these factors, with the possible exception of the strong dollar, are now changing.

Faster and accelerating wage growth will drive service inflation higher and, indirectly, other areas of inflation as well. Higher employment and household formation among younger population groups will drive demand for a limited supply of rental apartments, pushing the shelter component of the consumer price index higher. The dollar may well continue to strengthen but will probably do so more slowly, driving prices for imports higher on a relative basis.

Signs of higher inflation ahead

Just as current low inflation rates are due to the confluence of multiple factors, all pushing in the same direction, we can expect the reverse when all of those factors turn around, which they are doing.

We’re already seeing preliminary signs of higher inflation. If I had to guess, more serious signs should start appearing in the next six to twelve months, in line with faster wage growth. Arguably, this will be the final indication that the Federal Reserve has succeeded in bringing the economy back to normal.

Worrying about inflation, as everyone will be doing at that point, is something we older folks are quite familiar with. In some respects, it will be kind of comforting. But not really.

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