Anyone who read an economics textbook from 1970 to 2000 most likely came across a chapter on inflation. The damage inflation causes to an economy with uncontrollable price increases should scare any consumer or economist. It’s the result generally of poor monetary policy. An economic nightmare. However since 1996, PCE, the FOMC’s preferred inflation measurement has averaged less than 2% (see graph below). Are we really in an environment where we need to fear inflation?
Health care overhaul, tax reform, infrastructure spending, releasing animal spirits and other promises from our government to stimulate growth could cause some inflation. History suggests inflation is not a present concern unless you believe there are trillions in untapped potential growth that are about to be unlocked. Certainly the market has believed it as rates have moved much higher since the election. Since November 8th the 10yr has climbed from 1.86% to 2.36% today, up 50bps. The FOMC has also raised the benchmark short term rate 50bps: 25bps in December and 25bp in March. Given what’s happened, where do we go from here?
There are a few things to keep an eye on:
- Unemployment and job creation
- Inflation and Commodity Prices
- Fed Balance Sheet
It’s safe to say unemployment has met the Fed’s target although I’m concerned we haven’t moved much lower than the 5% target given how long rates have stayed near zero. Inflation is a big argument. Commodity prices seem to be very well contained, as does Core PCE, the Fed’s preferred measurement. Inflation expectations certainly have gotten ahead of themselves but if tax reform fails then those expectations will come back to reality. It doesn’t appear legislation will be an easy task and any continued failure to stimulate growth could put downward pressure on rates. Remember rates moved higher on growth expectations and those expectations are coming down slowly. The Federal Balance sheet needs to be addressed and if they start to unwind it in 2017, that could take the place of interest rate increases. Let’s not forget about Europe which is dealing with Brexit and at some point they will have a defining moment to address all of their issues. When you end the years of accommodation then you are forced to make choices, and the necessary choices are often unpopular .
The key to rates in the US will still hinge on PCE and GDP. These two figures are the ultimate measuring tool in assessing the strength of our economy. Yes the non-farm payroll report tomorrow can affect the market, but growth and inflation are not opinions and ultimately are what’s written on the scoreboard.
April 13th PPI
April 14th CPI
April 28th Q1GDP
May 1st PCE
Odds of 25bps higher rates by FOMC: