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US inflation: storm clouds on the horizon

US inflation: storm clouds on the horizon

 
January 2017

Patrick Zweifel, Chief Economist

Risks of a US inflation overshoot are rising. If economic growth remains strong, investors should be prepared for a price storm in 2018.

 

Inflation, like the weather, can be notoriously hard to forecast.  For this year, we already know most of the data which will drive US price pressures and the skies seem relatively calm. Nothing to worry about – at least until you look further along the horizon. There, the clouds are starting to gather and by 2018, the combination of stronger economic growth and US President Donald Trump’s expansionary fiscal policy could lead to a storm.

Economic growth in place

For inflation to really take off, a number of factors need to line up. The first – strong economic growth – is already in place. Activity in the US picked up markedly in the second half of 2016 and is set to remain buoyant over the coming months. Consumer confidence is at a nine-year high,1 while unemployment is hovering around a nine-year low.  Our own leading index is at its highest level since 2014.

The “Trump effect” is likely to further stimulate growth, with the new US president promising to boost infrastructure spending by up to USD500 billion and slash the corporation tax to 15 per cent from 35 per cent.

In this context, inflation could well rise quickly, bringing with it all the likely consequences – a more hawkish US Federal Reserve, higher interest rates, a stronger dollar and risky financial assets under pressure.

 
housing, health care costs adding to price pressures
Major components contributing to US core PCE inflation rate
US PCE by goods
Source: Pictet Asset Management, CEIC, Thomson Reuters Datastream
 

Inflation indicators are edging towards the red

Prices are already rising. Annual headline inflation hit 1.7 per cent in November 2016 – up from just 0.4 per cent a year earlier – and is likely to accelerate further to 2.5 per cent by the middle of this year, our models show.

For now, though, much of the price pressure comes from higher commodity prices, traditionally volatile inflation components over which the Fed has no control.

The central bank’s preferred inflation measure, the core personal consumption expenditure (PCE) index, rose 1.6 per cent in November, driven by higher rents and healthcare bills. The 2 per cent inflation rate the Fed targets is clearly no longer beyond the horizon. The question now is not whether it will be reached, but by how much it will be breached.

To judge this, we have looked at 30 inflation indicators across three channels through which price pressures typically build: economic activity, labour market and international factors, such as the exchange rate and global commodity prices. (A fourth channel – the money supply – follows a very different, long-term route and has become increasingly unstable with the adoption of quantitative easing.)

Twelve of these show a significant chance of inflation overshooting 2 per cent this year. Overall, our model now gives a 26 per cent probability of the threshold being breached within the next 12 months – compared with a 21 per cent reading in January 2016. This is very close to the 27 per cent level beyond which the probability becomes significant.2
rising risk of pricing overshoot
Probability of US core inflation surpassing 2%
US Inflation

* Core PCE inflation >2% and rising (i.e. 1-year change in inflation>0).  **R2 weighted average of probabilities of inflation estimated independently using 30 factors.  *** Determined as the average of estimated inflation probabilities since 1986.  Source: Pictet Asset Management, CEIC, Thomson Reuters Datastream, Bloomberg

Aside from commodity prices, the strongest inflationary pressures are coming from the retail sector and the housing market, although real estate prices are expected to slow down over the coming months. The US’s deteriorating productivity is another key contributor.

On the flip side, bond breakeven rates – a measure of the maket’s inflation expectation based on the difference between the yield on a fixed rate bond and that on an inflation-linked one – and overall activity measures and labour market indicators are among the metrics which suggest inflation is not a risk in the short term.

Even if core PCE growth reaches 2 per cent, it is unlikely to significantly overshoot the Fed’s target.  We can say that with relative confidence, given the lagging nature of price growth – it tends to lag economic and labour market trends by up to 20 months, inflation expectations by around a year and international factors by at least seven months. So, while inflation clouds have clearly appeared, any risk of a storm hangs firmly over 2018 rather than 2017.

More rate hikes?

What does that mean for the Fed? The signs point to more aggressive monetary tightening than the market expects. For now, we are sticking with our forecast for two 25 basis point increases this year, but there could well be more tightening if the central bank becomes concerned with the outlook for price pressures in 2018 and beyond. Much stronger than expected economic performance would be the most likely catalyst – and one which could be triggered by Trump.

We estimate his policies could add as much 1 percentage point to economic expansion next year, although some of that will likely be counteracted by other factors such as a stronger dollar and higher oil prices.

To maintain a positive (empirical) output gap, GDP growth would need to be beyond 2.7 per cent this year to make the inflation probability significant. Given our current forecast of 2.3 per cent expansion, this is a very distinct possibility.

We still believe that the Fed would still prefer to take the risk of higher inflation over that of hiking too early and tighten monetary conditions at a time when growth is not strong enough. However, if the current pace of growth is maintained throughout this year, it will start to become inflationary.  From an investment perspective that means it worth considering potential inflation hedges (see box). After all, it’s always prudent to pack an umbrella if there are clouds on the horizon – however distant they may be.

Investing for inflation: view from pictet am strategy unit

Many of the most obvious inflation hedges look expensive on our models.

 These include commodity producers, industrials and infrastructure stocks. In real estate, inflation-linked commercial rents should deliver an increased income stream but oversupply in key markets could eat into overall investment returns.

Inflation-linked bonds are not yet overvalued, but nor are they particularly cheap.

Here any benefits of inflation protection come with the potential performance drag from rising real rates - a trend that also holds true for gold. The latter's safe haven qualities, however, should offer some protection if the move in inflation turns out to be extreme and/or disorderly.

 Better value - and a more positive outlook - can be found in financials.

European energy companies and some segments of emerging markets also look relatively cheap and should benefit from reflation – particularly if it spreads beyond the US and to the rest of the globe.