January’s Consumer Price Index (“CPI”) indicated inflation rising to 2.5%. Analyzing economic data for the last decade has shown a historically low rate of inflation, compared to any other period in U.S. history. In 2020, we are seeing signs of more robust data that could show a higher rate of inflation going forward. Inflation expectations have been tame. Expectations adapt slowly to trends in the actual inflation data. This last decade does indicate a period of low inflation, however, it reveals a trend, and—most recently—an uptick in inflation. The last decade for inflation analysis is important as it followed the global financial crisis.
Inflation is the measurement that is used to monitor increases in prices over time. It is important to understand inflation from a historical perspective, and what goes into the measurement. Economists use the measurement to predict future trends, short term disruptions, and the current state of the U.S. economy.
Inflation is an increase in the price of goods and services as measured through time; it reflects price increases across the economy. Inflation of 2% means that prices of goods and services increase by 2% annually. One of the main responsibilities of the Federal Reserve Bank (The Fed) is to minimize volatility or extremes in inflation. The current Fed inflation target is 2%[i].This target is important because it indicates an appropriate increase in prices to maintain a healthy growing economy. Higher inflation can lead to recessions as the Fed would be forced to raise rates to slow inflation and thus slow the economy as well.
The main measurement for inflation is the Consumer Price Index. The index is a price calculation of a basket of goods and services. CPI measured on a yearly basis is currently 2.5%. A graph that measures CPI from 1950 would show that it is historically low when compared to inflation of the 1970’s, but let’s focus on the last decade. The U.S. economy has shifted from a manufacturer based to a service-based economy. Technology and global competition have kept inflation low and below trend when compared to the 20th century. This last decade is important as it reflects a period where the U.S. economy is leading the world in productivity and growth. Trends in current inflation are far more pertinent in analyzing the economy.
Tradition Asset Management analysis of inflation data below following the financial crisis indicates U.S. inflation has remained low. Previous theories between the strength of the economy and inflation trends have not materialized. Economists have developed reasons for this unique period of low inflation. Anchored inflation expectations have kept the rate low and less volatile. Globalization has played a bigger part in keeping inflation lower, longer. Advances in technology, capital markets lending, and changes in the overall methodology for measuring inflation all have contributed to this period of sustained sub 2% inflation over the past 10 years.[ii]
2019 was a great year for the stock market. The S&P 500 return was greater than 30% (source Bloomberg). Unemployment dropped to record lows and wages grew. (source Bureau of Labor Statistics) As illustrated in the chart above CPI, rose to 2.5% as of January 2020. In a growing economy, unemployment drops, wages rise, and people spend more money. This higher demand allows suppliers to increase prices, which leads to more jobs and more money being spent. We believe this type of inflation can signal a healthy economy. Too much inflation could cause prices to increase dramatically and compel people to spend less and risk tilting the economy into recession. Lower inflation also allows the U.S. government to spend more, as interest on the Federal deficit is low.
As mentioned previously, there are several factors that are used to create or drive inflation. Unemployment, wages, producer prices, interest rates, deficit spending, and energy prices were drivers in the past. During the 1970’s, the U.S. experienced volatility and high inflation. Inflation was greater than 11% during periods of the 70’s (source Bureau of Labor Statistics), and inflation was damaging to the U.S. economy. We can attribute the persistent high inflation to several factors. Moving from the gold standard, wage and price controls, energy volatility, and high interest rates were some reasons for the high inflation.
The CPI which has been the generally accepted measurement of inflation has three large components in its calculation. Housing, transportation, and food/beverages, in that order, are the main components. Prices rose in 2019 for many of the components of CPI. Housing is the largest component of CPI and is a good measurement of the overall economy as it has a ripple effect on other areas of the economy such as construction and manufacturing. Let’s look at two important measurements of housing over the last decade.
Housing, the largest contributor, to CPI has trended upward over the last decade, and most notably in 2019. There have been quarters of downturn as illustrated in all of the charts, but this trend is sustained by the upward sloping line in both charts.
The trend in inflation (CPI) illustrates an upward movement over the last decade, punctuated by an uptick in 2019. Core inflation, which excludes the costs of food and energy, should continue to trend higher. As indicated in the above charts the trend for housing starts and new home sales should continue to rise in 2020. According to the U.S. Bureau of Labor Statistics, in December 2019, the U.S. unemployment rate was 3.5%, the lowest level since 1969 which suggests inflation will continue to rise.
The trend, recent data, and history all suggest a modest rise in inflation for 2020. This may take the market and the Fed by surprise.
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[i] Federal Reserve Board and Federal Open Market Committee
[ii] Consumer Price Index – Bureau of Labor Statistics