Last updated: 08:33 / Wednesday, 21 September 2016
Analysis by Eaton Vance

Rising Inflation Pressures May Soon Force the Fed’s Hand

Rising Inflation Pressures May Soon Force the Fed’s Hand

The evidence suggesting significantly higher inflation momentum in the months and years ahead continues to build. A turn higher in the inflation cycle would likely trigger a reaction from the Federal Reserve on monetary policy, with important consequences for investors, according to Stewart D. Taylor, Diversified Fixed Income Portfolio Manager at Eaton Vance.

The latest Consumer Price Index (CPI) number showed that inflation rose a higher-than-expected 0.2% in August, marking the fifth positive CPI print in the last six months. After bottoming at -0.2% in April 2015, headline CPI is now advancing at a 1.1% year-over-year pace. More importantly, the core CPI, which removes food and energy, is rising at a 2.3% annual rate.

However, for the Asset Manager, there are other notable signs that the trend in inflation may have turned higher, including:

  • Services inflation, roughly 70% of CPI, continues to increase at a rate exceeding 2.5%. In fact, the core consumer services component (services excluding energy services) is growing at over 3%.
  • The Atlanta Fed Wage Tracker, a measure that adjusts for demographic changes in the work force, continues to suggest that inflationary wage pressures are quickly growing (see figure below).
  • Commodities have stabilized and started to move higher. For instance, crude oil is more than 30% higher than the low set in January 2016. This deflationary headwind is quickly turning into an inflationary tail wind.
  • Both presidential candidates have voiced support of protectionist trade policies that would potentially boost the prices of goods.

Taylor writes in the company's blog that investors and consumers have gotten used to low inflation after the global financial crisis. And to be fair, there are global crosscurrents that could keep inflation subdued. The global economy remains weak, and if growth slows further, the lack of demand could lead to more losses in commodities and goods sectors. Also, in China, some of the most pressured industries are only operating at 60% capacity, and the world's second-largest economy continues to "export" deflation in areas like steel.

Still, Taylor believes "investors should keep a close eye on any potential shift. Inflation, even modest inflation, acts as a hidden tax on wealth. And if the Fed's implicit target of confiscating 2% of your wealth every year wasn't onerous enough, now it is openly making the case that tolerating higher "opportunistic" inflation to drive growth may be desirable."

"Sluggish CPI growth and falling oil prices may have hidden the potential risks of inflation from investors. Many portfolios are underweighted in inflation-sensitive assets, and a change in the trend would catch many off-guard." He concludes.