January 16, 2018— December inflation, as measured by the Consumer Price Index (CPI), held steady on a year-over-year basis at 2.1%. However, the “core” measure, which excludes the volatile food and energy components, had a 1.8% year-over-year increase. Some of this was due to firming across categories, including prices in the housing and medical care categories, while an additional boost was received from some transitory price impacts including drug prices and used vehicles (which saw a pop in demand in 4Q 2017 following the destructive string of hurricanes in parts of the U.S.).
Financial markets reacted to the data, particularly in the bond market, with the confirmation of firmer inflation, capping an already-volatile week for interest rates. Key levels were reached for U.S. Treasury yields, with the 10-year yield rising above 2.5% last week—the first time since March 2017—and the yield on the 2-year yield touching 2% for the first time since before the financial crisis.
The evidence of inflation momentum building aligns with our core narrative and actually does not surprise us. We expect price measures to increase further in March of this year as a dramatic one-time decline in cell phone service pricing in March of 2017 will roll out of the year-over-year calculations. While it is common to analyze inflation compared to the same time the prior year, in fact, inflation has already returned to target on a shorter timeframe. The annualized CPI based on the prior three months of data is now 2.5%, and the 6-month annualized figure is 2.2%. For 2018, we are forecasting headline CPI inflation of around 2.5%. With that, we expect to see a rise across the Treasury yield curve, as evidence of building inflationary pressures should allow the Federal Reserve to hike its target rate three times this year, while signs of healthy growth and inflation are likely to keep elevated the yield on longer maturities.
To be clear, while the bond markets seem to be alarmed by inflation, we do not see the recent data as alarming. Yes, we may finally see the Core Personal Consumption Expenditures (PCE) price index—different from the CPI but the Fed’s preferred inflation measure—reach the Fed’s 2% target in 2018, but we do not expect inflation to increase fast enough to elicit a more hawkish response from the Fed than has thus far been telegraphed by voting members.
The U.S. price index for core personal consumption expenditures, minus the Fed’s 2% target (y/y %)
As of November 30, 2017. Source: Bloomberg, Bureau of Economic Analysis
In our view, there are three important structural causes of the low inflation we have observed during this economic recovery, none of which is going away any time soon: 1) demographics—an aging population is putting downward pressure on wages and prices; 2) global disinflation—trade has shrunk the global footprint, meaning low inflation in one part of the world is increasingly being “imported” to another part of the world; and 3) technology—difficult to quantify but hard to ignore, the Internet and companies like Amazon and Uber are disrupting the supply chain in new ways every day. We discuss the causes and importance of low inflation in greater detail in the first theme of our 2018–2019 Capital markets Forecast, Global Positioning Systems: Recalculating in light of detours, bumps, and blind spots.
We expect these structural forces to keep inflation from “running away” from the Fed, and to keep the Fed from hiking more than three times in 2018, even if economic growth receives a much-anticipated boost from tax reform. This shapes our view that the yield curve is unlikely to invert in the near term and the U.S. economic cycle has further to run, though we recognize the risk of lofty valuations at this point in the cycle. Our expectation of a continued “goldilocks” backdrop—firming inflation and solid economic growth, with a Fed that continues to move gradually—is a key reason for our overweight to equities. For more on key themes influencing our 2018 market outlook, please see our 2018–2019 Capital markets Forecast, Global Positioning Systems: Recalculating in light of detours, bumps, and blind spots.
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