18 December 2018
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Joe Davis
Vanguard's Chief Economist
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Is Inflation Heating Up? Not Really
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The markets were caught off guard at the end of January by a pickup inwages. Then came trade tariffs that likely will push up import prices. And oilrecently breached $70 a barrel. The effects of tax cuts and increasedgovernment spending are also coming down the pike. Inflation hawks are becomingincreasingly concerned. They will be watching the Federal Open MarketCommittee’s meeting June 12–13 to see whether these developments trigger a moreaggressive tightening trajectory from the Federal Reserve. 

Yes, inflation is moving higher, according to a number of broadmeasures. Those measures include the Fed’s favorite, the Personal ConsumptionExpenditures Price Index, which continues to approach its 2% target level.(That gauge has only rarely and briefly done so since the Fed instituted anexplicit target in 2012.) 

But higher isn’t the same as high. 

No cause for alarm 

In the outlook for 2018 that we published late last year, our economicsteam listed an inflation surprise as the greatest risk to the status quo.Global growth was becoming more synchronized at a time when 80% of the world’smajor economies were already at full employment, and commodity prices lookedset to rebound off recent lows. The result, we explained, was high odds of acyclical upturn in inflation in the United States and abroad—something themarkets weren’t pricing in at all. 

Don’t confuse the cycle with the trend 

A cyclical uptick in inflation, even if it temporarily overshoots 2%,wouldn’t cause the damage that hawks fear—a decline in the dollar’s purchasingpower or an imminent hike in longer-term interest rates, which could underminethe relatively high prices of stocks and other assets. 

Longer term, we expect the economy’s growth and inflation prospects toremain subdued relative to historical standards, as does the Fed—see itsforecasts in the figure below. Our research shows that long-term forces,including a shrinking labor force, technological disruption, and expandingglobalization will continue to weigh on prices for years to come. 

Those aren’t forecasts that should set inflation alarm bells ringing. 

What might “more aggressive” look like? 

We will have to wait for the Federal Open Market Committee to releaseits statement at the close of its June meeting to glean how the Fed isinterpreting the latest economic data. (An increase in the federal funds targetrate to a range of 1.75%–2.00% is widely expected at the meeting.) 

Our outlook on the Fed’s interest rate plans remains the same: 3 hikesin 2018 and 3 in 2019, taking the fed funds rate ultimately near 3% beforestopping and, by 2020, perhaps even a cut in rates. Our forecast anticipates a6-month “pause” in Fed tightening when the fed funds rate rises above 2% andabove the likely rate of core inflation after September. This is adifferentiated view, as was our view that the Fed would be “emboldened” toraise rates this year as unemployment rates continued to drop. So far, onpoint. 

Whatever the change, it won’t alter our longer-term market outlook. Wecontinue to urge investors to remain disciplined and globally diversified,armed with reasonable return expectations and low-cost strategies. The goodnews is that as short-term interest rates edge up, so will our expectations forlonger-term stock and bond returns, as the risk-free rate is the foundation forboth. 

Click here for the original blog article from Vanguard. 

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