In Search Of… Inflation

The Federal Reserve’s lofty 2% inflation target may be within reach this year.

The reality is that growth has begun to resume in the U.S. economy as states across the country start to reopen and life resumes some level of normalcy. The latest jobs report showed that 916,000 jobs were created in March, exceeding expectations for 660,000 jobs. The unemployment rate also dipped to 6.0%, compared to 6.2% in February.

A more active labor force is undoubtedly a positive sign for economic recovery and has inspired some economists to lift their GDP forecasts for 2021. For example, the International Monetary Fund (IMF) recently stated that it expects the U.S. economy to grow at a robust 6.4% pace in 2021, which is only second to China’s 8.4% forecasted GDP growth. If the U.S. achieves 6.4% GDP growth this year, it will mark the fastest pace since 1984.[1]

While we’re all pleased that the U.S. economy is rebounding strongly from the global pandemic, the rapid recovery has spurred expectations for inflation to increase. Federal Reserve Chairman Jerome Powell stoked these expectations in recent comments: “We expect that as the economy reopens and hopefully picks up, we will see inflation move up through base effects. That could create some upward pressure on prices.”[2]

Inflation has remained stubbornly below the Fed’s 2% inflation target for a few years now. However, Powell expects inflation to breach 2% “in the next year or so.” Interestingly, the latest Federal Open March Committee (FOMC) statement revealed that the Fed anticipates 2.4% inflation this year, up from previous estimates for 1.8%.

It is important to note that the Fed’s inflation indicator is the Personal Consumption Expenditures (PCE), representing final U.S. consumption. PCE is comprised of several components that we often break down into three categories: durable goods (vehicles, furniture, recreational), nondurable goods (food, apparel, energy/gasoline), and services (housing, medical care, transportation, recreation, hotels/restaurants, finance, non-profit).

The latest PCE reading for February showed the index increased 1.6% year-over-year, up from the 1.4% year-over-year rise in January. Core PCE, which excludes food and energy, climbed 1.4% year-over-year in February, compared to the 1.5% year-over-year rise in January.

The table below from the Bureau of Economic Analysis illustrates how the price of durable goods, nondurable goods, and services have increased on a month-to-month basis over the past year.

Another popular gauge for inflation is the Consumer Price Index (CPI), representing Americans’ out-of-pocket spending. There are eight main components of CPI—food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services—and energy.

For February, the CPI showed that consumer prices are also starting to rise. The Labor Department announced that its CPI rose 0.4% in February after gaining 0.3% in January. In the past 12 months, CPI has increased 1.7%—and, as you can see in the chart below, is expected to steadily rise this year.

In particular, food and energy prices have soared in recent months. Prices for food consumed at home increased 0.3% in February, while food eaten in restaurants or away from home rose 0.1%. Overall, the cost of food jumped 0.2% in February.

Regarding energy, we’ve experienced a significant surge in gasoline prices, which I’m sure you’ve witnessed at the pump. Gasoline prices soared 6.4% in February, following up January’s 7.4% increase.[3] The Energy Information Administration (EIA) recently revealed that gasoline is priced at about $2.87 per gallon in the U.S, or a $0.93 per gallon increase from early April 2020. Diesel prices have jumped nearly $0.60 year-over-year to $3.14 per gallon.[4]

The table below depicts how each component of the CPI has performed in the past year…

Inflation is starting to materialize and will likely continue to have an outsized impact vs. recent history as the U.S. economy recovers.

The fear with rising inflation is that it could impact purchasing power, especially for bond investors. The fact of the matter is that bond yields tend to increase with inflation and positive economic data, which, in turn, erodes the value of bond funds. On the other hand, owning bonds outright allows investors to ignore the negative impacts of rising rates (assuming they don’t need to sell), and their reinvestments’ yields may rise over time.

We need to remember that key interest rates remain near zero and are expected to remain ultra-low for the foreseeable future. The Fed stated that it plans to keep key interest rates near zero until at least 2024.

As a result, the bond market isn’t too concerned about inflation right now. Still, as even more positive economic data is released in the coming months and inflation continues its trek higher, one should consider how it could impact their fixed-income investments, which will disproportionately impact owners of bond mutual funds. In contrast, outright bond owners who plan to hold until maturity can ignore the negative impacts.

If you would like to learn more about inflation and key interest rates and how they could impact your investments, please give us a call at Nicollet Investment Management today.

Please click here for important disclosures.

[1] https://www.usnews.com/news/business/articles/2021-04-06/imf-upgrades-forecast-for-2021-global-growth-to-a-record-6

[2] https://www.cnbc.com/2021/03/04/fed-chairman-powell-says-economic-reopening-could-cause-inflation-to-pick-up-temporarily.html

[3] https://www.cnbc.com/2021/03/10/us-consumer-prices-rise-0point4percent-in-february-as-expected.html

[4] https://www.eia.gov/petroleum/gasdiesel/