A Bit More, But Not Too Much


November 13, 2017

Inflation has been low for years. There are signs, though, that this might change. GDP has moved up to around 3%, unemployment is low enough to raise expectations of wage pressure, and the capital markets are priced for perfection. Many would argue that a bit more inflation would be a good thing, but everyone would likely agree that we do not want too much. There are many economic and political risks at present, including the Fed balance sheet wind down, a new Fed chair, and proposed tax law changes. This is no time to let the inflation tiger out of its cage.

An increase in inflation would stimulate a re-think of interest rates, and any changes there would impact not just bond prices, but the market overall. Just as important for people in or close to retirement, extra inflation will increase the expense of living. Even small changes in inflation have a big effect in the longer term. For example, an inflation rate of 1.5% increases annual expenses of $100,000 to $119,562 over twelve years, while an inflation rate of 2.5% take annual expenses to $134,489. In other words 1% more inflation increases that same expense level by almost $15,000.

This is probably a good time to have a good understanding of the inflation measurements we see in the media:

Consumer Price Index (CPI) tracks prices of a fixed basket of goods bought by “urban” consumers. The data is derived from consumer surveys, which are not always reliable, and has a heavy tilt to household related expenses.

Personal Consumption Expenditures (PCE) tracks prices of a dynamic basket of goods that are bought by all types of consumers. The data is derived from business surveys, so for example picks up a more complete cost for health care which is partly paid by employers. This measure is preferred by the Fed. Like CPI there is a “core” PCE which excludes food and energy costs.

Underlying Inflation Gauge (UIG) which is quite new and was developed by the New York Fed. The calculation of UIG is complex, and produces two metrics: “prices-only” and “full data set”. There is not enough space to try and describe the calculation here (there is a very academic Economic Policy Review article which does this if you are interested), but the key thing to bear in mind is that the UIG seeks to forecast inflation trends more accurately than the other measures. Time is needed to see how useful this measure is.

Here is the inflation data for the year through end September:

CPI  2.2%
CPI, Ex Food and Energy (Core)  1.7%
PCE  1.6%
PCE, Ex Food and Energy (Core)  1.3%
UIG Prices-only  2.3%
UIG Full Data Set  2.8%

If the UIG data really provides a better forecast then it looks like an increase in inflation of around 1% may not be so far away. What does inflation feel like at your house? You may have your own indicators. One thing is for sure: evidence that inflation is rising too quickly will unsettle the market.

Lloyd Flood