For several years now, traditional inflation benchmarks have barely registered on the economic dashboard. As the U.S. pulls further away from the Great Recession of 2008—09, investors seem to have grown desensitized to what we might deem “The Boy (or Girl) Who Cried Inflation.” But here’s the thing about inflation: By the time it’s under your nose—meaning, entrenched and getting worse—it may be too late to stop it.
The Federal Reserve is our top cop in this department, and any monetary policy misfires by Janet Yellen & Co. could mean big trouble, probably necessitating significantly tighter interest rate policy while forcing investors to rethink their strategies.
To be sure, inflation remains subdued—for now. But that doesn’t mean you shouldn’t keep your eyes open for signs of percolating prices, and look for ways to capitalize. Believe it or not, an economy that tips toward inflationary growth can be beneficial, up to a point (read more in our introductory article).
So, what to watch for?
One of the best ways to gauge the Fed’s comfort or discomfort level with inflation trends is through speeches and Congressional testimony by central bank governors, or the statements from meetings of the Federal Open Market Committee, the Fed’s policy-setting arm. The quick-and-dirty Fed consensus on inflation? Nothing to see here.
Actually, inflation might be a little too low, the Fed seems to suggest. In an April 30 announcement following the most recent meeting, the FOMC said inflation continued to run below the committee’s longer-term objective, and noted that a rate persistently under 2% “could pose risks to economic performance.”
Still, the Fed has been sufficiently encouraged by recent economic signals to scale back its QE bond-buying program, which is expected to end by December.
Whether inflation picks up in coming years remains to be seen, but to some observers, red flags have already popped up. Old-school types point to overall money supply, which is three times the size it was in the beginning of 2008. Hawks argue that inflation isn’t widespread, yet, simply because the additional money has not circulated so well through a sluggish economy. As the economy improves, watch out. At that point, surging prices will be a symptom of underlying inflation already festering in high-priced assets, excessive money supply or a weaker dollar (more on this below).
The most helpful economic gauges project future inflation, rather than merely convey what’s already happened. Investors benefit from watching a handful of trending inflation indicators rather than, say, just the Consumer Price Index (CPI), because any one indicator can have peaks and valleys.
While CPI may be the government’s inflation benchmark, the Fed’s preferred measure is found in the fine print of GDP reports: the Personal Consumption Expenditures (PCE) deflator. The Fed likes the PCE because it accounts for goods and services “substitution,” includes a broader basket of prices and its historical data is more easily revised.
As an investor, your punch list could include the five-year “breakeven rate,” which reflects the difference in nominal interest rates on a traditional U.S. Treasury note and “real” (inflation-adjusted) rates on Treasury Inflation-Protected Securities, according to J.P. Morgan Funds Global Markets Specialist Michael Hood.
Wage Push And Pull
Wage trends are what really matters in the inflation pipeline, many economists agree. After all, the bigger your paycheck, the more you’re likely to spend (and vice versa).
One number to watch is the quarterly Employment Cost Index (ECI) released by the Labor Department. Recent readings indicate businesses are holding the line on wages, with the ECI rising a seasonally adjusted 0.3% in the first quarter compared with the fourth quarter of 2013.
Compared to the first quarter of 2013, the ECI rose 1.8%. The ECI would likely need to rise to 3.5% to 4.25% to stir inflation concerns, according to Hood. Still, other Labor Department numbers suggest wage growth is perking up (see figure 1).
“Labor market slack remains, but as the labor market tightens, wages are likely to continue to move upward,” TD Bank Senior Economist James Marple said. “Historically, the Federal Reserve has reacted to upward movements in wage inflation by raising interest rates. If the Fed is slower than usual to do so now, they run the risk of inflation pushing above their 2% target.”
Follow The Money
Foreign exchange patterns can also presage inflation. As a country’s currency depreciates, it becomes more expensive to purchase imported goods, which puts upward pressure on prices overall.
Over the long term, currencies of countries with high inflation rates tend to depreciate. Because inflation erodes asset values over time, investors often park money in markets with low inflation. That’s a big reason the dollar, by and large, remains almighty—the world knows its money is reasonably safe here.
Prices for copper, sugar, wheat and other raw materials are perhaps the most visible inflationary signals. Rising oil prices, in particular, can bleed through to the broader economy pretty quickly. While oil prices remain historically high, commodities generally aren’t ringing alarm bells at the moment. Farmers, miners and the like have the ability to ramp up production quickly, which tends to make commodity price spikes relatively short-lived.
Much of the worst-case inflation scenario is just that—it assumes the Fed’s plan goes awry and the central bank won’t act quickly enough to stanch surging prices. Remember, there’s no on-off policy switch for controlling inflation. It’s a moving target.
For investors, here’s a possible takeaway on inflation—don’t fear it, revere it. That’s right, some inflation (as opposed to none, or worse, deflation) is actually OK. It means the economy is expanding and demand for goods and services is growing. Some industries and asset classes benefit from inflationary forces. Being mindful of inflation risks simply means that you and your portfolio are agile, too.
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