Orlando's Outlook: Core inflation grinding higher

03-31-2017

Bottom Line Rising inflation is the perennial scourge of fixed-income investors, as the resulting erosion of purchasing power forces bond vigilantes to demand higher nominal yields and lower prices to compensate for the additional risk. So, with the all the conventional inflation metrics we monitor slowly rising to multiyear highs, the Federal Reserve’s recent path toward a tighter monetary policy appears to be the correct course of action.

What’s confusing to us, though, is that over the past three weeks or so, benchmark 10-year Treasury yields have actually fallen, from 2.63% to 2.35%. We suspect that’s just a short-term, counter-trend, flight-to-safety rally in bonds, as equity investors needed a near-term place to hide as the S&P 500 corrected 3.3% amid the recent health-care policy debacle in Washington.

Looking across the proverbial valley, we continue to believe stronger economic and corporate earnings growth and rising levels of inflation due to potential structural fiscal-policy reforms by the Trump administration will prompt the Fed to continue to hike interest rates. This should drive both bond yields and stock prices higher over time.

Core inflation continues to quietly grind higher This morning, the Department of Commerce reported the core personal consumption expenditures (PCE) index—the Fed’s preferred measure of inflation—rose to 1.8% in February 2017 on an annualized year-over-year (y/y) basis. It also revised January’s reading up a tick to 1.8%. Those are the highest levels we’ve seen since October 2012, a more than 4-year high. So core PCE inflation, which had troughed at 1.3% in July 2015, has been moving higher over the past two years, although it remains below the Fed’s oft-stated 2% inflation target.

Importantly, over the past three months, core PCE inflation on a month-over-month basis has inched up 0.2% in February, 0.3% in January and 0.1% in December, which translates into an annualized increase of 2.5% on the basis of this 3-month core rate. So the more recent 3-month data shows an accelerating trend of core inflation over the trailing 12-month results.

New wholesale inflation metric rises sharply The core y/y wholesale inflation producer price index (PPI), which strips out volatile food, energy and trade prices, rose to 1.8% in February 2017, a 2½-year high that matches similar peaks from November 2016 and August 2014, when this new data series was first introduced. Importantly, this core metric, an important measure of pipeline inflation, had troughed at a deflationary annual reading of only 0.2% in November 2015. Wholesale inflation trends have improved sharply over just the last 15 months.

Elevated retail inflation trading range The core y/y consumer price index (CPI), a retail inflation measure that strips out volatile food and energy prices, slipped a tick in February 2017 to 2.2%. That’s down from 2.3% in January 2017, which matches its highest reading in nearly five years (April 2012). Retail inflation y/y had troughed at 1.6% in December 2014, from which point it rose sharply to 2.3% in February 2016, an elevated level that it subsequently matched in August 2016 and again this past January.

Wage growth recovering Wage inflation troughed at a 1.5% increase y/y in October 2012, and rose 2.8% annually in February 2017. Other than a spike to a 2.9% growth rate in December 2016, this is the healthiest wage growth has been since June 2009, which is when the Great Recession was coming to an end. We expect this positive trend to continue, with wage inflation rising up to perhaps 4% y/y over the next two years.

Energy prices have bottomed Crude oil prices, as measured by West Texas intermediate (WTI), had plunged 75% from $108 per barrel in June 2014 to a 12-year low of $26 in February 2016. Since then, crude has more than doubled to $55 per barrel in this year’s first quarter. That’s because Saudi Arabia finally got serious about coordinated production cuts to firm prices with an historic OPEC and non-OPEC accord to cut 1.8 million barrels a day from production starting this past January 1. A trading range of perhaps $40-60 per barrel now seems appropriate over the balance of 2017. But that sharp recovery in crude—and a narrower trading range over the past several months— has helped to stabilize nominal inflation trends.

Housing prices accelerate Home prices in the 20 largest U.S. cities rose 5.7% in January 2017, their fastest pace since July 2014, according to the lagging Case-Shiller index, which measures housing prices on a rolling 3-month average basis. Both new and existing home sales have been strong, thanks to low mortgage rates, a solid labor market, rising wages and increased household formations, while prices have risen steadily due to a lack of inventory. The strength of the housing market has contributed to the increase in both nominal and core inflation, a trend that we anticipate will continue.

Upside risks to economic growth and inflation? The Fed recently hiked interest rates by a quarter point at it mid-March 2017 meeting, its second such hike in three months’ time and third hike since exiting its zero-bound policy in December 2015. Our house view is the Fed is on tap to hike two more times this year. But in light of the increase in inflation and the continued strength in the labor market, some policymakers are hinting that perhaps a more rapid retreat from monetary-policy accommodation is appropriate, with maybe three or more hikes this year. In addition, the Fed may also begin to unwind its $4.5 trillion balance sheet before the end of calendar 2017, which we expect will be Janet Yellen’s last as Fed chair.

Moreover, Fed officials have said they have not factored into their thinking any of President Trump’s fiscal policy plans, which, if passed, may spark faster economic growth and inflation. That, in turn, could prompt the Fed to hike even more quickly to stay ahead of the curve.