One question the Federal Reserve can’t seem to answer is why, over the past few years, inflation has remained so low. The incredible monetary policy of quantitative easing, the Fed’s asset purchasing program, has put trillions of dollars into the economy, yet inflation has remained well below their 2% target.
That may be about to change in the year 2018.
The recent CPI report showed that core consumer prices jumped .349% in January, which was the largest month-over-month gain since March 2005. Core inflation is now running at a 3-month average of 2.88%, which is the highest since 2008. The CPI recorded a .5% monthly gain.
This wasn’t the first sign of inflation. The 10-year treasury yield jumped to a 4-year high after the January jobs report showed rising wages and higher consumer confidence. The Department of Labor released data showing average hourly earnings rose .3% for the month of January, reaching an annual gain of 2.9%. This is the strongest wage growth since 2009, just after the financial crisis. The Labor Department also revised its December wage readings upward to .4% from .3%.
Higher earnings signal that the labor market is tightening, putting upward pressure on wages. This uptick in labor costs and an elevated CPI could mean inflation isn’t too far behind. Minneapolis Fed President Neel Kashkari, after the January jobs report, stated that “The most important thing that I saw in a quick review of the jobs data is wage growth”. Kashkari says “This is one of the first signs we’re seeing of wage growth finally starting to pick up.” He concluded that if wages continue to rise, it “could have an effect on the path of interest rates”, potentially prompting more aggressive action from the central bank to keep a lid on inflation.
The Federal Reserve, after Chairman Janet Yellen’s last Federal Open Market Committee meeting, signaled that it expects inflation “to move up this year”, hinting at a possible quarter percent rate hike in March. This raises the concern that the central bank may have to expedite rate hikes to four this year. In December, the Fed projected it would raise rates only three times in 2018.
Treasury Yield Reaction
Treasury yields reacted strongly to the data. After the CPI data was released, the yield on the benchmark 10-year note jumped, reaching 2.92%, its highest mark since January of 2014. It had previously eclipsed a prior four-year high after the strong January jobs report. The 10-year yield increased rapidly from 2.5% to around 2.8% within just a 3-week span. The 30-year yield rose above 3% , the highest level since March 2017.
This fast pace is forcing many equity investors to adjust their economic outlook, spurring the increase in stock market volatility. This has been demonstrated through the spike in the VIX as well as the massive fluctuations in the DJIA . Higher bond yields put pressure on stocks because treasuries begin to look more attractive, especially if the yields are higher than the inflation rate and the average S&P 500 dividend yield.
The rise in bond yields, which move inversely with prices, suggests that investors believe the Federal Reserve will have to hike interest rates faster than anticipated to combat potential inflation. The yields on 5-year treasury inflation protected securities is also rising, recently achieving its highest level since 2009.
Cause For Concern?
The anticipation of inflation is already prompting forecasts with reduced GPD estimates. JP Morgan slashed its GDP estimate down to 2.5% from 3% for the 1st quarter. They implied that the tightening labor market will embolden the Fed to hike rates at a faster pace. “Today’s inflation reading should probably cement in place the Fed’s intent to hike rates at the March FOMC meeting” said Michael Feroli, JP Morgan Chief US Economist, after what he described as a “Hotter than Hades” CPI report. The Atlanta Federal Reserve also lowered its 1st Quarter growth to 3.2% from 4% after the report, citing that the Fed could revise their plan for the year and go from three hikes to four.
Various Fed Presidents have offered input on the prospects of increased rate hikes in 2018. Dallas Fed President, Robert Kaplan, stated that higher wages don’t necessarily mean faster inflation. However, he suggested that the Fed should “gradually and patiently” raise the federal funds rate in 2018. Kaplan expressed concern that if the Fed waits too long to remove monetary accommodation, it will “ultimately [have] to play catch-up”, which could trigger a recession.
Chicago Fed President Charles Evans said he would be open to keeping central bank policy on hold until mid-year, giving officials enough time to properly analyze a possible inflation trend. Evans affirmed that he doesn’t see inflation reaching 2% until 2019 or even early 2020.
Philadelphia Fed President, Patrick Harker, is going against the consensus. Before the release of the Fed’s January minutes, Harker implied that two rate hikes this year were appropriate, though he was open to more if necessary. At St. Louis University, Harker defended his reasoning as being“based on a relatively strong economy, but the continued stubbornness of inflation”.
Federal Reserve Response
The recently released Monetary Policy report, a report conducted by the Fed and given to Congress, stated that the “labor force market appears to be near or a little beyond full employment at present”. Though it did not give clear guidance on future hikes, it did imply that the Fed expects inflation to reach its 2% target soon. Since the report didn’t give any indication about four rate hikes, Treasury prices rose after the report, pushing yields lower.
The January Fed minutes, released just a few days before the Monetary Policy report, gave a similar message of growing confidence in inflation rising to the central bank’s benchmark. Whether this prompts more proactive action remains to be seen. However, despite the uncertainty around the Fed’s 2018 intentions, the 10-year yield is creeping ever closer to 3%, once again implying that bond investors see four hikes this year.
Chairman Powell, in his first testimony to the House Financial Services Committee, vowed to continue the path of three consistent and gradual rate hikes, but did not rule out a fourth. “We’ll be taking into account everything that happened since December,” Powell said in reference to the fiscal stimulus of increased government spending and tax cuts as well as a strong labor market. The Fed Chairman stated that a forecast for 2018 will come at the FOMC meeting in March, but that he wont “prejudge” the forecast. The 10-year yield reached 2.91% after Powell’s comments.
There are several factors that could further contribute to inflation. A dollar that continues to weaken paired with a tightening labor market could raise inflationary pressures. Furthermore, the expansionary fiscal policy of an unfunded $1.5 trillion-dollar tax bill, coupled with the recent federal spending bill and a potential $1.5 trillion-dollar infrastructure plan, could further heat up and already strong economy, pushing inflation higher.
However, there’s still no clear evidence of any inflationary trend. Rising labor costs have yet to demonstrate a sustainable course, and technological advances may be keeping prices down. Nor is it clear if the Fed will conduct a faster pace of hiking in 2018 or gradual rate hikes into 2019. Jay Powell, in his rookie year as Fed Chairman, must walk a tight rope with raising rates and trimming the Fed’s balance sheet. The first indication of their plan could come at the FOMC meeting in March.
Under Chair Yellen, the Fed claimed to be strictly data dependent, but how will they interpret the data this time? Will they see the inflation indicators as just a blip, or a more sustainable trend?