Is there a current inflation threat or not?

 

On one hand, overall Consumer Price Index (CPI) reports, the U.S. housing market, the U.S. labor market, and Federal Reserve (Fed) monetary policy seem to be telling us that inflation remains under control, at least in the near term.(The CPI is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.)

On the other hand:

• Some consumer prices (particularly for energy, transportation, and health care) showed significant gains in 2010.
• Producer prices (especially farm products) are putting pressure on consumer prices.
• Commodities and precious metals prices showed recent strength.
• Potential inflation indicators in the U.S. Treasury market are flashing warning signs.

 

At a time of mixed economic and inflation signals like these, which do you watch if you’re concerned about inflation? Which do you pay the most attention to?

Categorizing the Inflation Signals into Two Groups

The answer, actually, is virtually all of them, as long as you understand what they represent.

It helps to categorize the signals into two groups:

1. Backward-looking signals, which tell us more about where we’ve been than where we’re going.

2. Forward-looking signals, which are based on financial market expectations.

 

These categories will allow us to sort the signals, and interpret them in the appropriate context.

Backward-Looking Signal Summary—Past Price Trends Were Mixed

 

This category is composed primarily of prices and price indices—CPI, producer prices, commodities prices, etc. Yes, their momentum can indicate future price movements (via trend analysis, mean reversion analysis, etc.), but you’re mostly looking in the rear-view mirror instead of looking ahead.

These signals have given us a muddy inflation picture. The CPI, one of the most widely watched indicators, rose considerably less in 2010 (1.5%) than it did in 2009 (2.7%). Increases in CPI’s so-called “core components” (without food and energy) also decelerated, from 1.8% in 2008 and 2009, to 0.8% in 2010, the smallest annual increase in the index’s history.

But energy was up 7.7%, and food accelerated from a 0.5% decline in 2009 to a 1.5% increase in 2010. Farm products in the producer price index (PPI) rose 18.4% in 2010, and other commodities posted solid gains. Clearly, one could argue that though overall consumer prices have been well-behaved, there appear to be some increasing inflation pressures growing in the producer-price pipeline.

Forward-Looking Signal Summary—Treasury Market Has Been Pricing in Future Inflation

 

This category is composed largely of Treasury yield indicators—including:

• Long-term Treasury yield levels and movements
• The difference between long-term Treasury yields and short-term yields
• The difference between the yields of nominal Treasuries and TIPS (Treasury inflation-protected securities) of the same maturity—so-called Treasury breakeven rates

 

The Treasury market, like the stock market, is a discounting mechanism—it discounts (prices in) expected economic trends and risks.

 

These signals, unlike past price trends, are not mixed—they unanimously indicate that possibly higher inflation appears to be a risk in our future, reflecting the present point of view and concerns of the bond market. Bond traders try to anticipate future economic conditions and the risks that result. Right now, they’re seeing the stimulative monetary and fiscal policies that the Fed and U.S. government are executing, and projecting their impact on the U.S. dollar, budget deficits, debt levels, the money supply, and consumer demand.

 

To the bond market, these policies appear to be inflationary, resulting from a weaker dollar, rising budget deficits and debt levels, money supply growth, and increased consumer demand. So bond traders are holding out for lower longer-term government bond prices and demanding higher long-term bond yields to compensate for the inflation risks they see down the road, even as short-term yields remain relatively low (because of Fed policy—see below). This wide difference between short- and long-term Treasury yields (a “steep yield curve”) can be viewed as a harbinger of future inflation, as can increasing Treasury breakeven rates.

 

Short-Term Interest Rates May or May Not Be Forward-Looking

 

What about low short-term yields and interest rates, by themselves? What do they indicate? At the beginning of this piece, we cited the current, accommodative Fed policy (keeping U.S. interest rates low and increasing the U.S. money supply by buying government bonds) as a sign that inflation appears under control. Some would say that the extremely low level of short-term interest rates in the U.S., which are tied to Fed policy, are also a harbinger of continued low inflation. But that’s not necessarily the case today, as we’ll explain.

Generally, if the Fed is concerned about inflation, it will start raising its short-term interest rate target (the overnight federal funds rate target) and reducing the money supply. Also, if the bond market thinks the Fed is about to start boosting rates, it will go ahead and start pricing in higher short-term bond yields well ahead of any actual Fed activity. So, under most circumstances, extremely low short-term interest rates (such as CD rates and money fund yields), like we have presently, would be considered a sign of low inflation and low inflation expectations.

But that’s not true right now. Instead, the Fed appears more concerned about increasing economic growth than fighting inflation—it appears willing to increase the risk of higher future inflation in return for improving U.S. economic growth in the near term and preventing a double-dip recession. In other words, today’s low short-term interest rates are more in response to economic weakness than a low inflation-risk indicator.

We’ll know when the Fed is more concerned about inflation risk than deflation/recession risk when it begins raising short-term interest rates. That doesn’t appear likely to happen until 2012.

The Declining Dollar Factor

 

It's also worth pointing out that the Fed's accommodative monetary policies are putting potential downward pressure on the value of the U.S. dollar. The dollar received some support at the end of 2010 from “safe-haven demand” caused by the sovereign debt turmoil in Europe and geo-political turmoil elsewhere, but the dollar was down over 8% in the last six months of 2010 against its major trading partners, has resumed declining since January 7 of this year, and, in the view of many economists and analysts, appears likely to decline further in the longer-term because of Fed and government policies and their long-term impact on the U.S. economy. A weaker dollar means that imported goods such as oil, clothing, and many foodstuffs will become more expensive, translating to higher gasoline, clothing, and food prices.

Tying the U.S. Housing and Labor Markets to Inflation Expectations

We mentioned at the start of this piece that the housing and labor markets seem to indicate that inflation remains under control. Why would we say that?

Let’s look at housing first. Housing represents 43% of the CPI and is a large component of consumer net worth. The current, ongoing housing market slump (since prices peaked in 2006-07) has a wide-ranging dampening impact on demand and pricing in a number of industries and categories, including construction, wood products, mortgage financing, etc. As long as housing stays in the doldrums, a significant segment of the economy will not be generating inflation pressures.

Similarly, the weak labor market and high unemployment rate are also dampening demand and costs in a number of areas, not the least of which are wages and other compensation. Wages and other compensation are typically among the biggest, if not the biggest, cost components that businesses face. When the labor market is soft and wage and benefits pressures stay relatively low, it reduces the need for businesses to pass along those costs to consumers in the form of price increases. As long as the economy remains relatively weak, and companies can find ways to maintain or increase production without hiring more workers, wage pressures will remain low. And as long as wage pressures remain low, overall inflation is more likely to remain low.

Conclusions

 

What can we derive from all of this? It can be mostly boiled down into two main points:

1. Economic fundamentals seem to argue for continued low inflation in the near term. The U.S. economy, along with much of the developed world, is still struggling to exit the financial crisis and Great Recession. That's keeping unemployment high and wage pressures low. As long as that remains the case, and turmoil overseas helps support some of the safe-haven value of the U.S. dollar, it appears that inflation can be kept under control.

2. However, financial markets are now pricing in the possibility of higher future inflation. We're seeing that in higher long-term Treasury yields, a steep Treasury yield curve, and higher TIPS breakeven rates.

 

Point #2 suggests that investors should make sure they have some "inflation insurance" in their portfolios, such as:

• TIPS and other inflation-linked securities
• International bonds and other non-dollar investments (non-dollar-denominated investments can perform well for U.S. investors when the U.S. dollar declines)
• Commodities and/or commodity-related securities
• Precious metals and/or precious metal-related securities
• Real estate and/or real estate-related securities
• “Ready-made” investment portfolios that offer combinations of these “inflation insurance” sectors

 

As the old saying goes: “The best time to buy flood insurance is when the river is still running low.” We suggest not waiting until inflation pressures increase further before making sure you have some inflation insurance in your portfolio.

American Century Investments^® offers a wide variety of stock, bond and asset allocation funds. Visit americancentury.com for more information: U.S Investment Professionals

The opinions expressed are those of American Century Investments and are no guarantee of the future performance of any American Century Investments portfolio. This information is not intended to serve as investment advice; it is for educational purposes only.

You should consider a fund’s investment objectives, risks, and charges and expenses carefully before you invest. The fund’s prospectus or summary prospectus, contains this and other information about the fund, and should be read carefully before investing. Investments are subject to market risk.

© 2011 American Century Proprietary Holdings, Inc.

American Century Investment Services, Inc., Distributor

www.americancentury.com

 

 

 

 

 

 

 

 

 

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