Roman Chuyan, CFA

May 12, 2016

The Fed (and other central banks globally) helped keep bond, stock and other asset prices elevated, in the face of negative fundamentals including economic and valuation. How will the tug-of-war between fundamentals and the Fed be resolved? One possible scenario: inflation reaches the Fed’s target and forces it to tighten monetary policy.

The Fed has been trying to boost inflation since it dropped following the financial crisis in 2008-09, and it finally turned up this year. In fact, core (excluding food and energy) consumer price index (CPI) inflation is at 2.2% (see chart).

CPI Inflation Rates, 20 Years

Total inflation rate, having rebounded from its 2015 low of around zero, is still low at 0.85%. It is important to understand the dynamic between total and core inflation rates. By design, total inflation includes both core inflation and the more volatile food and energy prices. If commodity prices didn’t change, total inflation would be very close to the core inflation rate. As commodities fluctuate, total inflation fluctuates around the more-stable core inflation (see chart above), but always reverts back to core.

Since last year, total inflation rebounded despite the continued plunge in crude oil (see chart below) and other commodities. Commodities stabilized this year – for example, WTI crude oil price rebounded to $46 per barrel. While the future path of commodity prices is uncertain, if they remain stable it’s only a matter of time before total inflation (currently at 0.85%) catches up to core (2.2%). CPI statistics will be released next on May 17, and are worth keeping an eye on.

Inflation Rate vs. Crude Oil Price, 10 Years

The Fed’s preferred inflation gauge is the change in the core personal consumption expenditures (PCE) price index, which now is at 1.6%, still below CPI inflation.

To summarize, while the Fed’s preferred inflation measure, at 1.6%, is still below its 2% target, core CPI inflation recently rose to 2.2%. Commodity rebound will push total inflation up to that level, likely in only a few months. If PCE inflation follows these other measures, it will force the Fed’s hand in raising interest rates in order to moderate inflation, as its mandate dictates.

Model Capital Management LLC is a tactical investment manager. For details about Model Capital’s fundamental, forward-looking approach to tactical investment management, visit here; review the list of our tactical management strategies here. Please contact us for information on how we work with advisors.