Inflation: Up and to the Right

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Inflation: Up and to the right... that's the description you want to hear about a chart of the stock you own. Why? Because it suggests the stock price is trending higher. That's a good thing and it will undoubtedly make you feel happy, but what if you were told a chart of the inflation rate was up and to the right? How might that make you feel?

From an investor's standpoint, the answer to that last question will have a lot to do with whether they own stocks or bonds. Rising inflation isn't good for the fixed-income set, whereas it has less onerous implications in general for equity owners.

Read Five Key Factors for Investors to Focus on in 2017

A little inflation emanating from a strengthening economy can go a long way for the equity crowd. Things get more troublesome, though, when inflation rises in a hurry and necessitates some stepped-up tightening action from the Federal Reserve.

We're not there yet of course, but concerns about the inflation rate hitting some escape velocity of its own this year are bubbling beneath the surface.

Up, but Not High

Let's lay some inflation groundwork first.

One is hard-pressed looking at the headline readings for both the Consumer Price Index (CPI) and the Personal Consumption Expenditures (PCE) Price Index to suggest inflation is high right now. Based on the latest reports, the CPI is up 1.7% year-over-year while the PCE Price Index—the Federal Reserve's preferred inflation gauge—is up just 1.4%. That compares to their 30-year averages of 2.7% and 2.2%, respectively.

The inflation rates, as seen in the charts below, may be moving up and to the right in recent months, yet a wider-angle lens also clearly indicates that they aren't "high" at their current levels.

inflation rates

Inflation Risk

Market participants, though, are rarely bothered by what they know about things now. What preoccupies their mind the most is where they think things are headed.

In that vein, the assumption is that the inflation rate will be moving higher. That assumption is grounded in the following considerations:

  • The likely introduction of fiscal stimulus in 2017
  • The specter of the Trump Administration imposing increased tariffs on major trading partners
  • The possible implementation of a border tax that raises the cost of goods made abroad for sale in the US
  • Increased immigration control
  • A pickup in wage growth with the labor market running near full employment
  • Rising oil prices; and
  • Animal spirits kicking in on pro-growth optimism

There is ample reason to think rising inflation is in the air, but thus far, it can also be said that the market remains inclined to think that inflation won't take off as some pundits fear.

That perspective has manifested itself in the 5-year breakeven inflation rate, which implies what market participants expect inflation to be in the next five years, on average. That breakeven rate today stands at 1.86%, although it, too, has been moving up and to the right of late.

five year breakeven

Strikingly, the Fed's longer-run target for PCE inflation is 2.0%. That's higher than the 5-year breakeven inflation rate, which is yet another signal that genuine inflation fears are being repressed for the most part even though a lot of talk about rising inflation is in the air.

This speaks to the risk for the market if inflation does, in fact, pick up pace beyond the Fed's target. Remember, the Fed's latest projection indicates three rate hikes are likely in 2017—and that's with a median estimate that PCE inflation will be 1.9% in 2017 (the range for all participants' projections is just 1.7% to 2.0%).

Hear US Economic Outlook With Andrew Zatlin

In any event, the December employment report provided some ammunition for the inflation hawks, with average hourly earnings increasing 2.9% year-over-year. That is the highest growth rate since May 2009 and it provided another indelible mark on an inflation chart moving up and to the right.

average hourly earnings

The chart above also shows there is more room to run with wage growth to hit pre-recession highs, yet the trend itself is one of the compelling trends for the economy and the prospect of headline inflation continuing to move up.

Employed consumers are literally earning the ability to spend more than they have in recent years—and that's before there is any benefit from a possible cut in personal tax rates.

Consumer spending drives GDP growth, and if GDP growth is picking up, it stands to reason that headline inflation will pick up along with it.

All Price Changes Not Created Equal

Notwithstanding the relatively tame headline inflation readings, inflation has already hit home in a big way for many consumers.

The headline reading is just that. It is a measure of the average change in prices over time of goods and services purchased by households. Every household, though, doesn't purchase all of the same goods and services at the same time.

There are some generally common expenditures each month on items like food, gasoline, and housing, yet there are plenty of generally uncommon expenditures like airfare, TVs, and major appliances that take place more infrequently, but which also have an effect on the CPI computation.

For instance, a closer look at the CPI report for November reveals that the cost of food at home declined 2.2% year-over-year on an unadjusted basis. If one eats a lot of meat, that was a good thing as meat costs were down 5.1% year-over-year; however, if one eats a lot of fresh fish and seafood, pricing conditions weren't as consumer-friendly as prices rose 3.6% year-over-year.

In the food category, then, there was both deflation and inflation.

For TVs and major appliances, there was outright deflation, as prices were down 24.8% year-over-year for TVs and down 7.3% year-over-year for major appliances. Accordingly, if one needed to buy a TV or major appliance in the month of November, they most likely scored a pretty good deal.

The point being is that the headline reading might be what the Federal Reserve responds to, yet it might not have any true meaning for a lot of consumers based on the basket of goods and services they buy in any given month.

This is partly why the relatively benign headline inflation reading gets shot down each month as being a fallacy by angry consumers paying much higher prices for things like prescription drugs, food away from home, school tuition, car insurance, pet care, financial services, and rent.

Be that as it may, the Federal Reserve is moved by the general level of prices, and that is why it has walked such a dovish line with its monetary policy for such a long time now, armed with the understanding that the year-over-year change in CPI has averaged 1.4% since March 2009 while the year-over-year change in the PCE Price Index has averaged 1.3%.

What It All Means

The Federal Reserve has been reluctant to pull the rate-hike trigger so as not to choke off recovery efforts. Some feel that reluctance has created a heightened risk of the Fed falling behind the curve on inflation, such that if inflation does heat up in the short run beyond the Federal Reserve's longer run target, it will force the Federal Reserve to raise rates more, and faster than expected.

If that situation manifests itself, it poses one of the biggest risks to this bull market run as a quicker pace of the inflation rate moving up and to the right will invite increased rate hikes that will interfere with many stock charts currently moving up and to the right.

That's one important reason why there will be an inflation fixation in 2017.

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About Patrick O'Hare