Jul 18, 2016 | Post by: Roman Chuyan, CFA Comments Off on Where Inflation Will Come From –

Where Inflation Will Come From –

Roman Chuyan, CFA

July 18, 2016

The Federal Reserve has been trying to boost inflation since the financial crisis, and inflation finally did begin to rise this year. In fact, core (excluding food and energy) consumer price index inflation was at 2.2% in June (the orange line on the chart below).

CPI Inflation Rates and Wage Growth, 20 Years

CPI and wage growth - tactical investment management

Sources: Bureau of Labor Statistics, Federal Reserve Bank of Atlanta

Some data suggest that inflation pressures are rising this year, as I highlighted previously – including continued rise in housing costs and the recent pickup in wage growth. According to the Atlanta Fed’s Wage Growth Tracker, which measures year-over-year change in median wage (the blue line above), wages increased by 3.5% from last year in May, its fastest growth since wage growth fell precipitously in 2009. This is very good news for employees as their real (after-inflation) wages are finally growing. However, it might also mean somewhat-higher upward pressure on prices.

Total inflation (including volatile food and energy prices) rebounded last year despite the continued plunge in crude oil (see chart below) and other commodities. Commodities stabilized this year – for example, crude oil price seems to have settled in the mid-$40 range. While still below year-ago levels, most commodities have rebounded strongly from their January-February lows: the CRB Index is up 7% YTD. Just released on July 14th, the producer price index rose by 0.54% in June from previous month, after rising 0.36% in May.

Inflation Rate vs. Crude Oil Price, 10 Years

Invflaiton vs Crude Oil - tactical investment management

Rising inflation will push interest rates up (bond prices down), and may force the Fed to hike short-term Fed Funds rate in order to contain inflation, sooner than currently expected. The view that inflation will rise is still uncommon – although some asset managers voiced concern (e.g., Goldman and DoubleLine), most observers still expect continued low-inflation environment. If the rise in inflation is sharp, the selloff in the bond market might be significant.

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