The Lowdown on Inflation

Why is inflation an important topic of discussion right now ?  

It’s all about interest rates and where they are going down the road. So far, even with a pretty strong economy, the U.S. Fed has been able to keep rates historically low because inflation has been modest. If it starts to accelerate and threatens to get well above the Fed’s 2% target, then the Fed will respond by raising rates faster, and higher, than what most people currently expect. That has implications for all asset markets, so that’s why inflation is front and center right now. 

How should we look at inflation?  At what level does it become a threat to the continuing health of the U.S. economy ?

What you want is for people to expect a stable and modest pace of inflation in the future. If inflation is too cold, meaning people think prices will stay really low, or even drop (deflation), they’ll hold off on buying goods and services. That will lead to slower economic growth. If inflation is too high, or running hot, you’ll get less for your hard-earned money, and people will be worse off. A little inflation, though, is just right. It sort of greases the wheels of the economy.

How much of an impact does Fed policy really have on controlling the inflation rate and has the Fed been managing inflation effectively, in your opinion ? 

It’s easy to judge the Fed’s performance because they have an explicit goal to keep inflation at a 2% target, which they take to mean prices are stable. In that respect, they have fallen short for most of the last two decades. Frankly, it’s not necessarily the Fed’s fault. There have been so many structural changes in the economy, especially as it relates to technology, that have led to a breakdown in the way we think the inflation process works. The Fed can certainly still choke off high inflation with rate increases, but it’s less clear that easy Fed policy can boost low inflation. 

What has a greater influence on inflation, the Fed’s increasing of rates, which should have a mitigating effect, or the Government’s current fiscal stimulus like the recent tax cuts, which should spur inflation ?

Good question, and this was a big topic of discussion at the Euromoney Inflation Conference. I would say the Fed wins this one. The way the stimulus was constructed isn’t going to lead to a surge in consumer spending that will generate inflation. A lot of it was meant to spur investment. If those investments boost productivity, then they’ll actually lower inflation down the road. So, it’s tough to see how the stimulus leads to much faster inflation. 

Has the change in the U.S. administration and subsequent change in Fed leadership changed how the Fed is confronting inflation ?

The administration’s stimulus package has certainly gotten the Fed’s attention. We haven’t had a situation when an already strong economy got juiced up via stimulus since the mid-1960s. Fed officials are aware that back then, inflation accelerated sharply a couple of years later. So, they’re watchful because of the stimulus, but this isn’t the 1960s.

When we do experience a rise in inflation, what is likely to happen to the bond and equity markets ?

Bonds hate inflation, so any signs of accelerating inflation is bad news for bonds. For equities, it is a bit more mixed, as a rise in inflation could mean some firms have better pricing power, and possibly better profits. So, it could be a buying opportunity. In terms of when we’ll see faster inflation, that’s not clear. It’s tough to see a scenario when inflation really moves up to 3%-4% from the current 2% pace.

Classic economics says there’s a correlation between inflation and employment.  Why haven’t we seen higher inflation with such tight employment ?

If I had the answer to this, I’d probably win a Nobel prize! Historically, this relationship was about lower unemployment leading to higher wages, which then translated to higher inflation. It hasn’t worked in 20+ years, and economists are re-examining its usefulness in how we think about the inflation process. The reasons offered range from the rise of companies like Amazon and Walmart, who keep prices low because they care about market share, to technological improvements that give everyone a chance to shop for the best prices on their phones, to globalization, which has flooded the country with cheap goods. There’s some truth to all those reasons, and I would add the decline in bargaining power for employees to that list.

Where do you see the U.S. inflation rate in the next 6 months or year ?

The Fed’s preferred inflation measure is known as the core PCE index. It strips out volatile prices like gasoline and food and gives a better idea of the inflation trend. For that measure, I think we could see it possibly edge a little lower from its current 2% rate. The big caveat here is tariffs. If the administration moves forward with more tariffs, consumers will almost certainly be paying more, and that will show up in the data. That’s not the kind of inflation the Fed wants to see, though.

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