Monthly Spotlight – May 2015

Who Cares? It Is Just a Little Inflation

While most people in the developed world spend little time dissecting the inflation story, those in finance have a more acute focus. Consumers certainly can point out what costs more today than in the past, but in many cases, they may substitute chicken breasts for steaks and leave it at that.

Market participants, on the other hand, closely follow the tea leaves of price changes to extrapolate the value of a U.S. dollar (or Euro) down the road. High inflation takes a hefty bite out of investment returns and individuals’ purchasing power, while deflation can choke economic growth as wages fall and consumer spending retrenches.

Mindful of the past, modern day central bankers typically set monetary policy with a 2% inflation target in mind. Ultimately, inflation is a vital factor in the decision making process for investors, consumers, and policy makers alike.

Since the Crisis

Low interest rates with muted inflation have prevailed since the 2008 financial crisis. Zero interest rate policies and other unconventional moves by governments and bankers have done little to push inflation above their 2% targets.

Since most policy moves over the past six years have not accomplished their goal – higher economic growth and higher prices – most central banks, including the U.S. Federal Reserve, have kept short-term interest rates lower for longer than anyone imagined.

Winds of Change

Continued improvement in the U.S. labor market has been a bright spot. Unemployment has dropped from over 10% in 2009 to 5.5% – normally a sign of a healthy economy and broader inflationary pressures. However, many economists, bankers, and others have
discounted the recent improvement in the labor market. Their rationale is that shrinking labor supply actually overstates the fall in unemployment because many people have given up on their job searches. This group of people, supposedly, will resume their search if salaries rise, which will dampen future wage inflation.

So how much lower can the unemployment rate go before we see rising wages? Where did all of those workers go, and when are they going to resume their job searches? While economists have struggled with explanations and answers, we believe that the anecdotal evidence is mounting and deserves attention.

Many states in the U.S. increased minimum wages starting in 2015. Coincidentally, a few large retail and restaurant chains announced significant lower-level wage hikes (much higher than minimum wage) earlier this year. Some companies were quick to conform and others will have to follow suit to remain competitive. We view both outcomes as a new, higher floor for national wages at the lower rung. Coupled with labor shortages in various sectors, these wage increases help to gather momentum for inflation. While rising pay is not the sole factor behind inflation, it certainly aids higher consumption and fuels broader price increases.

Home prices are also rising. Yes, home prices are well off the bottom, but it is the cost of renting that might cause sticker shock. We have written about changing demographics and lower home ownership rates in the past, and rising rents are the result. High rental costs push people to become roommates, co-inhabit, or marry. Higher household formations usually lead to babies, tempering the declining birthrate, a trend that has been in place since 2009. It is not hard to see the positive implications for consumption due to this demographic stabilization and its future inflationary effect. As usual, it is all about the kids!

Lastly, let us pause to point out the elephant in the room – six years of highly inflationary monetary policy. The dynamics of these policies will play out in the long-run, with potentially severe consequences for inflation if mishandled by policy makers. In the more immediate future, if our view of the job market and rising wages proves correct and the base effects of last year’s oil price declines wear off, the Fed will increase short-term interest rates – potentially catching some market participants off guard.

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