Inflation Picks Up Steam
The Personal Consumption Expenditures index, the Federal Reserve’s preferred measure of inflation, rose to 2 percent annually through the end of March. This means we’ve now entered the Fed’s target inflation range of 2-3 percent.
Inflation has been increasing in 2018 for a number of reasons. Americans’ wages saw the biggest quarterly increase in 11 years during the first quarter, resulting in more spending on goods and services. Likewise, consumer spending, which is a substantial chunk of U.S. GDP, increased in March after not changing in February. Also, as a mathematical result, very low inflation during early 2017 is rolling off of the commonly cited 1-year inflation figure, creating an inflated average. Higher oil prices and a tightening housing market are also contributing to the rise.
For investors, increasing growth and inflation are pushing yields up – a good sign we’re still in the expansionary phase of the economic cycle. This doesn’t mean investors should let everything ride. Instead, investors should ensure they’ve minimized the effect of inflation by avoiding long-term bonds with low fixed interest rates. In the meantime, companies which are able to pass through price hikes to buyers will protect or increase profit margins.
We expect rising inflation to continue due to a variety of factors such as wage growth and many of President Trump’s policies including tariffs, trade negotiations and limits on immigration.
With tariffs, one country decides to impose a tax on specific goods from another country. Theoretically, this causes inflationary pressures as companies pass on the costs of the tariff to consumers. The tariffs imposed by the U.S. government on worldwide steel and aluminum have not yet gone into effect. Many see it as a strong-arm negotiating tactic used to receive trade concessions from countries like China on a variety of issues ranging from steel imports to intellectual property rights. That said, we could see higher inflation if the tariffs go into effect or the world goes into a trade war where sweeping tariffs are introduced.
Limiting immigration levels is another inflation driver. Lower immigration results in a smaller overall labor force, which has acted to increase inflation rates in the past. For example, if ten people compete for a single job, the wages paid to the person who gets the job would be lower than if only two people were competing for the job.
On the consumer side, with higher inflation seemingly on the horizon, what can you do? The number one thing you can do is avoid variable interest rate debt. The largest instance of floating rate debt we see are in mortgages, but virtually any debt security can have a floating rate.
Higher inflation is often coupled with higher interest rates, meaning the rates of any floating rate debt will increase as inflation increases. Check any debt instruments you have to make sure they are fixed rate. If any debt is not, see what you can do to convert it to fixed or pay it off entirely.
Inflation is still quite low by historical standards. And, we do not see a repeat of the 1970’s on the horizon — a period when inflation exceeded 10 percent. If inflation rises too quickly, the Fed might be inclined to raise U.S. interest rates more aggressively to keep it from getting out of hand. In the meantime, the use of technology around the world provides a structural force keeping downward pressure on inflation that will continue for the foreseeable future.
We will continue to monitor the speed and impact of rising interest rates on our markets and economy and make adjustments to our clients’ portfolios as warranted.