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Inflation, a primary determinant of interest rates, is rising noticeably higher but interest rates have not yet reacted. Investors have enjoyed the corporate earnings and equity price increases associated with 2018’s stronger economic growth, but so far have seemed to ignore the increase in inflation also associated with that same growth. The Consumer Price Index (CPI) in June and July was up 2.9%, still low by historical standards, but nevertheless the fastest pace in six years and up noticeably from 2.1% in 2017. Core CPI for July increased to 2.4%, the fastest pace since September 2008. Similarly, the Employment Cost Index (ECI) tells a story of increases that had been absent in the past several years. The ECI for June grew at 2.8% year over year, the largest increase since 2008. Importantly, the private sector wages and salaries component of the ECI was up 2.9%, a new high for this cycle. At these levels, the ten-year Treasury yielding 2.9% offers a real return of close to zero. Looking forward, economic growth, producer prices, and tariffs all suggest inflation will move higher through 2018 and 2019. As inflation continues to increase, investors should plan for an accompanying adjustment in interest rates.
More Inflation to Come
Stronger economic growth in 2018 seems positioned to assure additional inflationary pressures in coming quarters. A June 13 Seeking Alpha article concluded that U.S. inflation is expected to continue to rise, supported by the author's analysis that changes in GDP tend to lead to changes in CPI by about six quarters. If higher inflation today has its roots in the economic strength of 2017, even stronger growth so far in 2018 will likely impact inflation in 2019, especially as labor conditions continue to tighten. Through the first seven months of 2018 job creation has averaged 215,000 per month, stronger than the 182,000 per month in 2017. With unemployment down to 3.9% and the broader U6 measure of unemployment at 7.5%, a new low for the cycle, 2018’s more rapid economic growth seems likely to amplify the wage pressures, and the broader inflationary pressures, that have started to unfold.
Additional Inflationary Pressures
Other indicators also suggest inflation pressures are building. The Producer Price Index was up 3.4% in June 2018, again a notable increase from 1.9% in June 2017. More worrisome to the Federal Reserve (Fed) are long-term inflation expectations. They too have risen lately. Ten-year inflation expectations are now at 2.13% compared to 1.65% a year ago, according to the Federal Reserve Bank of Cleveland. Using a slightly different measure of inflation expectations, the Federal Reserve Bank of St. Louis recently tracked the five-year/five-year forward index at 2.25%, a noticeable upward adjustment from 1.94% one year ago. Continued increases in inflation expectations will weigh heavily on Fed policy decisions.
To a large extent inflation and inflation expectations have yet to reflect much of the impact of tariffs. Even before the imposition of 25% tariffs on $200 billion of additional Chinese imports, anecdotal evidence suggests that tariffs on washing machines, steel, and aluminum are translating into higher prices. The laundry equipment component of CPI may best illustrate the impact tariffs can have on prices. In the wake of washing machine tariffs implemented on February 7, followed by steel and aluminum tariffs on June 1, laundry equipment rose 19.8% for the three months ended June 2018. Steel and aluminum tariffs contributed to the 20% jump in aluminum mill shapes and the 12% increase for steel mill products for the year ended June 2018. These increases are likely to bleed into everything from construction costs to home appliances over the next 12 months. Construction costs and housing costs will also be impacted by tariffs on Canadian softwood lumber.
Fed Rate Hikes
Even without the effects of tariff inflation, price increases due to stronger economic growth will not be lost on the Federal Reserve. The Fed's projections at their June meeting for two more increases in fed funds this year and three more next year are not likely to be adjusted lower. The Fed’s June projections assumed economic growth of 2.8% in 2018, lower than the 3% that seems likely to unfold. The increase in economic strength, combined with the inflationary effect of tariffs, are likely to encourage the Fed to at least fulfill its June projection of five rate hikes between now and the end of 2019. Given the potential for higher inflation, a sixth rate hike could become a consideration.
Interest rates and fed funds futures suggest that investors do not expect inflation to increase, and that they do not believe the Fed will raise rates as aggressively as it has projected. Only one rate hike is discounted by fed funds futures by year end, 2018; the Fed’s projected rate hike for December is not fully discounted until March 2019. Beyond that, only one more hike is fully discounted for all of 2019. The disparity between Fed projections and investor expectations seems likely to be resolved by inflation, in favor of the Fed.
Expect 3% growth and the effect of tariffs to produce higher inflation and inflation expectations, resulting in tighter Fed policy and higher interest rates. If the Fed follows through on its projections to raise fed funds over the next 12 months and ten-year Treasuries rise to just 3.5%, portfolios that mirror the yield and volatility characteristics of the Bloomberg Barclays U.S. Bond Aggregate Index can be expected to produce negative returns, assuming portfolio yield of around 3% and duration of about 6.0. Investors who ignore building inflationary pressures and fail to adjust their fixed income holdings could face surprisingly unpleasant returns between now and year end 2019.
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