Consumer Price Index

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1 The Return of Inflation? Yet another Fed meeting has now come and gone without a rate hike. As much as market participants continue to obsess over when the Fed will normalize interest rates, the Fed Funds rate still sits at just 25 basis points. 1 This is despite an economic recovery that is now eight years old (quite extended by historical standards) and an official unemployment rate below 5%. Clearly, despite all of their rhetoric to the contrary, Janet Yellen and company have been in no hurry to take away the punch bowl of easy money. While the Fed has cited a number of excuses in recent months to refrain from tightening monetary policy (the dollar, Brexit, China, etc.), perhaps the most important factor that has allowed them to keep rates so low has been a lack of inflation. We think that is about to change. A pending rise in inflation may finally force the Fed to tighten monetary policy, which would have wide-ranging effects on global capital markets. Background In the aftermath of the Global Financial Crisis, central banks around the world unleashed an unprecedented degree of monetary stimulus. After traditional monetary policy (i.e., lowering interest rates) failed to stimulate a sufficient economic recovery, Quantitative Easing ( QE ) became the policy tool of choice. This immediately led to fears of runaway inflation as all of this money printing was bound to drive up the price of everything from houses to groceries. But these inflation fears were based on a fundamental misunderstanding of what QE really is 2, and ultimately proved unfounded as the Consumer Price Index ( CPI ) continued to languish month after month Consumer Price Index Percentage (%) Technically the Fed establishes a target range (currently 25-50bps) and the Effective Federal Funds Rate (the rate at which depository institutions lend money overnight) is 40bps as of September 20, While central banks print money as part of QE, they use that money to buy bonds from banks. In other words, QE is just an asset swap whereby banks receive cash for bonds of the exact same value, leaving the amount of money in the financial system unchanged., LLC A SUBSIDIARY OF MEKETA INVESTMENT GROUP, INC 5796 ARMADA DRIVE SUITE 110 CARLSBAD CA fax

2 Eventually, markets began to assume that inflation would remain at these depressed levels indefinitely. While it is difficult to quantify exactly what level of inflation is priced into markets at any given time, there are a number of ways this can be estimated. Perhaps the most straightforward is the breakeven inflation rate (the difference between the yield of a nominal bond and an inflation-linked bond of the same maturity.) As shown in the chart below, the five year breakeven inflation rate has been trending lower for the past three years and currently sits at just 1.3% Year Breakeven Inflation Rate Percentage (%) Another metric commonly used to measure inflation expectations is the Treasury term premium. The term premium is the excess yield (i.e., compensation) that investors require to commit to holding a long-term bond as opposed to a series of short-term bonds. In other words, it is the premium that investors demand to protect them against a future rise in inflation. Today, the ten year Treasury term premium is actually negative, and close to the all-time low reached in

3 10 Year Treasury Term Premium 1.0 Percentage (%) While there are other reasons why investors would prefer long-term Treasuries (e.g., potentially a more effective downside risk hedge) and central bank intervention has clearly distorted bond markets to some degree (more on this later), it is clear to us that markets are not expecting a pick up in inflation any time soon. Oil Prices and the CPI Base Effect A key part of our thesis of rising inflation has to do with the calculation methodology of the Consumer Price Index (CPI). The CPI is a weighted average of the prices of various consumer goods and services meant to represent the spending patterns of the average American household food, housing, medical costs, etc. One of the largest and most important components of the CPI is energy. Not only are explicit energy costs (e.g., gasoline) an important expense for the typical American household, but the cost of energy is also embedded in the price of just about everything else. Thus, swings in the price of energy (i.e., oil prices), can have a significant impact on the level of inflation. It was no surprise, therefore, that the collapse in oil prices from over $100 per barrel in the summer of 2014 to a low of $27 per barrel in February 2016 put significant downward pressure on the CPI. But this downward pressure is only temporary. The CPI is calculated on a rolling one year basis, i.e., the rate of change over the prior twelve months. So while an oil price collapse initially creates a disinflationary impulse (i.e., a negative twelve month return), its effect wanes over time and eventually disappears entirely once it drops out of the CPI s rolling twelve month window (i.e., once we are more than twelve months removed from the collapse.) Said differently, for the price of energy to reverse and begin putting upward pressure on inflation, oil prices don t need to rise, they just need to stop falling. 3

4 This dynamic is illustrated in the chart below. As oil prices fell from a high of over $100 per barrel in mid-2014, the rolling twelve month return (used in the CPI calculation) collapsed as well, eventually reaching a low of -50% year-over-year. But as oil prices began to stabilize, the rolling twelve month return began to creep back towards zero. Oil s rally off the lows of mid-february has further accelerated this process. As of the end of August, the rolling twelve month return for oil is roughly 0%. But assuming oil prices remain at roughly their current levels ($45 per barrel) through the end of the year, the rolling twelve month return will reach as high as +34%. In other words, barring another collapse in oil between now and the end of the year, energy prices will have shifted from a major drag on inflation to a major driver. 110 Oil Price Rolling 12 Month Return Forecast 40% Price per Barrel ($) % 20% 10% 0% -10% -20% -30% -40% -50% Rolling 12 Month Return 30-60% This will also come at a time when the other major subcomponents of the CPI are already running well above the Fed s 2% target. Housing (Owners Equivalent Rent), Medical and Services are all over 3% as of last month s CPI report. The only thing depressing the overall CPI number has been energy costs, and as we have just explained, that is likely to change moving forward. 4

5 Services Housing (OER) Medical CPI YoY Change (%) Market Impact Normally an increase in inflation of this magnitude wouldn t be such a cause for concern, but these are unusual times. As we showed earlier, the market s expectations for inflation are extremely low, and thus, the surprise factor could be significant. Perhaps more importantly, disappointing economic growth and central bank stimulus (Zero Interest Rate Policy and QE) have helped to drive interest rates down to historic lows. If inflation starts to pick up, will investors still be willing to hold long-term bonds at these levels? 5 10 Yr Treasury Yield (%) 4 Yield (%)

6 What about equity markets or other asset classes? Initially, an uptick in inflation could very well be perceived as a positive development. After all, markets have been concerned with deflation (i.e., the Japan scenario) for the past few years. Thus, the potential negative effects of higher inflation may be initially outweighed by the removal of deflationary concerns. Furthermore, central banks have been trying for years to generate sufficient inflation to ease their countries debt burdens and may tout this as mission accomplished. Third quarter GDP growth will likely prove to be a critical variable. If a rise in inflation is coincident with a pick up in economic growth, it is much more likely to be viewed positively. If, however, the recent downtrend in GDP growth continues, rising inflation may trigger market fears of a stagflationary environment i.e., low growth and high inflation where both bonds and stocks tend to perform poorly. This would be a particularly risky outcome given the current valuation levels of both asset classes. Fed Reaction Perhaps most important of all will be the Fed s reaction. A strong reaction from the Fed in the form of rate increases (or at least a change in tone) could lead to a significant recalibration of forward rate expectations. In this scenario, a sell off in the bond market which then spills over into other asset classes via higher discount rates is the most likely outcome. If recent history is any guide, however, the Fed will be much more muted in their reaction. The Fed has been extremely cautious in removing monetary stimulus for fear of disrupting the ongoing economic recovery and upsetting financial markets. Thus, it seems more likely that the Fed would initially down play inflation risks as transitory rather than as a catalyst for immediate policy response. Summary The recent collapse in oil prices has masked the inflation pressures building in the US economy. That is likely about to change. The market impact of higher inflation, however, remains uncertain. The two key near-term variables are GDP growth and the Fed policy response. A continuation of sluggish economic growth and a more hawkish Fed could spark a sell off in the US bond market that would spill over into other risk assets around the world. Conversely, higher inflation that is accompanied by improved economic growth and a dovish Fed may actually prove to be a risk on catalyst, at least temporarily. Even in that scenario, however, persistent inflation would eventually lead to the bond market beginning to worry that the Fed is behind the curve on raising interest rates and effectively raising rates for them (i.e., capital outflows leading to lower bond prices and higher interest rates regardless of what the Fed says or does.) Potentially complicating matters even further, if the Fed is forced to tighten policy due to rising inflation, they will have less ability to loosen again should the markets or economy take a turn for the worse. While the full implications are not yet clear, rising inflation is likely to be one of the more important developments as we move through the rest of this year. We will be monitoring these events very closely and will communicate any changes to our current thinking. 6