How long does the Fed wait until Inflation Returns?
Inflation can be defined as a general upward price movement of goods and services in an economy over a period of time. In general, when the price levels rise, each unit of currency within an economy buys fewer goods and services. A certain amount of inflation is healthy for an economy while a high level of inflation can be crippling – remember 1980 when inflation levels were as high as 14.8%? On the other hand, excessively low inflation, potentially leading to a period of deflation (i.e. a decrease in the general price level of goods and services) if the inflation rate goes negative, can be just as destructive to an economy.
Inflation in the U.S., as measured by the Consumer Price Index (CPI), fell for a second straight month in September as increases in the costs of items such as food were essentially offset by decreases in the costs of items such as gas. According to the Bureau of Labor Statistics (BLS), the CPI represents changes in prices of all goods and services purchased for consumption by urban households. Consumer prices declined 0.2% in September, their largest monthly decline since January of this year, according to the monthly CPI report (including food and energy) from the U.S. Labor Department. The fall in overall costs of goods and services drove the annual inflation rate to zero, reaching a level last seen in 2008. Once energy prices begin to rise again, we believe that CPI will return to the trending levels we saw heading into 2014.
Why do these current inflation readings matter? They matter because the Federal Reserve (“Fed”) has set a target inflation rate for the U.S. economy of 2%. Though the Fed tends to prefer Personal Consumption Expenditures (PCE) data over CPI for inflation assessments and generally like to look at longer term readings as opposed to one single report while also discounting the effects of volatile items such as food and energy, the September CPI reading of 0% would certainly be of concern to the Fed. We believe that the inflation concern, in general, more than likely was the primary driver behind their “no-action” decision in September as opposed to any of their other stated concerns with respect to international economic growth or the Chinese markets in particular.
While a valid argument can be made that a higher inflation reading would be beneficial to the current state of our economic recovery, one would have to question if a 2% inflation rate target is still appropriate in order for the Fed to consider an initial rate hike if the housing market has stabilized, Gross Domestic Product (GDP) growth continues to trend in the positive direction and employment has improved markedly in the U.S. (though improvement in wages are still needed and concerns over the labor force participation rate persist)? At this time, we still believe that an initial rate hike in 2015 is still likely (and appropriate from our standpoint) and that interest rates will remain low for the foreseeable future given the long and gradual path of future interest rate hikes that we believe the Fed will follow during this particular period of tightening as the U.S. economy (followed by other global economies) continues to slowly recover.
Disclosure: The overview above is for informational purposes and is not an offer to sell or a solicitation of an offer to buy any of the themes discussed.