With the U.S. Presidential election in the rear-view mirror, and Republicans maintaining control of both the House and Senate, expansionary policies are likely to drive the demand side of the inflation equation.
This should have implications for the pace of rate hikes as the U.S. Federal Reserve (the Fed) attempts to contain inflation. We have already seen headline inflation numbers trend upward with supply side price pressure coming from oil and rents.
At this point, measured rate increases from the Fed are expected. However, a lot will depend on the success of fiscal stimulus to drive demand, therefore, changing the pace of the Fed. Given this backdrop, we believe fixed income investors face volatility in the near-term, as oil prices find stability. Additionally, volatility over the next several years is a concern as the balance is found between fiscal and monetary policy.
Mounting Inflationary Pressures
Inflation, which is a key driver of interest rates and Fed Policy, is caused by demand and supply side pressures. Demand side inflation is generally caused by an easing of monetary conditions or economic growth, which leads to increased spending by consumers, thus driving prices up. Supply side inflation occurs when the cost of a good rises due to scarcity or other factors that impact the availability of that good.
With the Trump administration’s proposed expansionary fiscal policy, demand side inflation could be driven by tax cuts for individuals and corporations, which would put more money in the economy. This increases consumption and prices. Additionally, proposed increases in government spending on infrastructure would create further demand side pressure.
On the supply side, we have seen inflation trend up as oil prices have rebounded from their lows, as well as the recent news of OPEC’s agreement to production cuts. Rents have also trended upward due to the scarcity of rental units as construction has lagged demographic shifts over the past few years.
Inflation indices measure the price of a basket of goods that the typical consumer purchases. The weight of these goods in the index will vary over time with their relative importance. For example, rent gets a higher weighting due to its heftier portion of the typical consumer’s budget. As can been seen in the chart below, rising rents (shelter) have pushed the weighting up over time, with a sharper increase more recently as supply is lagging. This, coupled with a rebound in oil prices this year, has led to an uptick in the Consumer Price Index (headline CPI).
While headline inflation indices measure the price of all goods and services in the consumption basket, and have implications for inflation expectations and nominal interest rates, core inflation indices exclude the more volatile food and energy components. However, both methods include rents. The Fed has stated that they prefer to follow Core PCE, since it is “most consistent over the longer run with the Federal Reserve’s statutory mandate.” (FOMC Press Release 1/25/12).
While Core PCE, the Fed’s favored measure, has trended upward, it has been more stable and remains below the Fed’s 2% target rate. Since it excludes oil, it would not be impacted from oil price increases. Conversely, headline CPI does include oil and has continued to trend upward for several months.
The difference in the components used when measuring inflation can have meaningful implications because the fixed income market often responds to the more volatile headline CPI, while the Fed may be slower to react based on their focus on core PCE. For example, breakeven inflation rates have risen over the past few months, as the bond market has moved firmly to price inflation in due to the recent upward trend in headline CPI. Additionally, there has been a recent modest uptick in real rates. This suggests the market is pricing in the beginning of a measured tightening cycle in 2017.
This is concerning for bond investors given, prior to the oil implosion, the component value for shelter in headline CPI was approximately 8% lower in June of 2014. The spike in shelter was caused by a supply shortage, and it may take a while for building to catch up to demand making this a stickier number. This makes increases in oil prices a significant threat to the fixed income markets in the shorter-term as the Fed’s preferred measure excludes oil. Increased demand fueled by expansionary fiscal policy may lead to spikes in other components of the indices. A lot will depend on how proactive the Fed becomes in response to changes in the components of Core PCE over the next year given broader economic conditions.
A Divergence of Policy
With the economy reaching full employment and an uptick in the monetary growth rate, the Fed is expected to enter a tightening cycle and we expect to see several rate hikes in 2017. In her November testimony before the Joint Economic Committee, Janet Yellen indicated that the data points suggest continued modest improvement, which would keep the Fed on a measured route. However, she indicated if conditions changed, they would change course. Leaving room for a faster pace as a divergence of fiscal and monetary policy may force a more aggressive stance.
An accelerated course for the Fed could likely be the case if expansionary fiscal policy is successful in creating jobs and the unemployment rate falls below the natural rate. This would be seen as an additional inflation threat on top of what would be expected from tax cuts and infrastructure spending, thus prompting the Fed to pick up pace. It is also likely there would be a pick up in the Fed’s course of rate hikes if expansionary fiscal policy leads to an increase in output, along with an increase in the neutral interest rate (the interest rate level at which real GDP is growing and inflation is stabilized). Therefore, if conditions create an increase in the neutral rate of interest, the Fed will have to move faster to keep up and prevent inflation.
As we wait to see the impacts of the Trump administration’s expansionary fiscal policies, we believe the bond market will experience volatility as it is more sensitive to moves in headline inflation (CPI). Upward pressure on nominal interest rates (real rates plus inflation) will likely depend on oil prices and the expectations of increased demand pressures on other components. Long-term interest rates could move higher before the Fed is prompted to provide relief.
In our opinion, it is likely the Fed will not let growth get out of hand and, therefore, any growth and inflationary pressures stemming from expansionary fiscal policy will be met by a faster, counteractive Fed policy. This leaves a lot of uncertainty on the demand side of the inflation equation. While the supply side will remain under pressure from low rental supply and now more support for oil prices with OPEC agreeing to cut production, it is not likely we will see headline CPI reversing its recent trend near term. With this backdrop, we believe rates could move higher near-term with spikes in oil or increases in inflation expectations due to demand pressures. However, interest rates will be mostly range bound until the Fed aggressively moves to slow the economy or induce a recession. Therefore, we believe fixed income investors face volatile times as oil prices find stability and there is a balance found between fiscal and monetary policy over the next few years.
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