Is inflation a real and present danger?

Inflation has been deader than a dinosaur’s doorknob ever since the end of the financial crisis. But a growing number of fund groups and research firms have started to make the case for higher inflation in the next few years. Only time will tell if they’re correct, but you should be familiar with the arguments — and be prepared if they are right.

The government’s consumer price index has gained just 1.6% the 12 months ended in June — 1.7% if you exclude food and energy. The PCE deflator, the Federal Reserve’s preferred inflation measure, has gained 1.5% the past 12 months. And the implied 10-year inflation rate for Treasury Inflation-Protected Securities currently stands at 1.8%.

Nevertheless, two major voices have been sounding the inflation tocsin recently: BlackRock and Vanguard.

“As the unemployment rate continues to come down, then, from a top-down perspective, the slack in the economy will decline and ultimately put upward pressure on wages and put modest upward pressure on inflation,” Martin Hegarty, managing director at BlackRock, told Bloomberg Businessweek.

“The underlying trends in core inflation will be higher,” said Gemma Wright-Casparius, portfolio manager at Vanguard, in the same article.

It’s reasonable to worry about inflation, which is one of the key factors in anyone’s financial plan. There’s a world of difference between a retirement with 2% inflation and one with 4% inflation. And the dearth of inflation in the past few years has been puzzling.

The classic upward wage-price momentum starts with low unemployment, forcing employers to offer higher wages to keep and retain workers. As wages rise, so do prices, continuing until the Federal Reserve raises interest rates, slows the economy, and relieves wage pressure. The Phillips Curve, named after economist William Phillips, shows that inflation typically takes off as unemployment falls.

Jim Paulson, economist at the Leuthold Group, argues that inflationary prices are already rising.

“Don’t fade inflation risk,” he warns in a letter to clients. “Phillips may be alive and well in the contemporary recovery: Measures of wage inflation suggest it has intensified in the last couple years, several labor market indicators hint that job market pressures should worsen in the balance of this recovery, and finally, signals from the commodity, currency and bond markets warn about complacency surrounding inflation.”

His evidence: “Average hourly earnings have accelerated from about 2% to 2.5%, median wage inflation has risen from about 2.25% to about 3.25%, and median weekly earnings of wage and salary workers has jumped from about 1.5% to almost 4.25%!”

But John Lonski, managing director and chief economist at Moody’s, isn’t so sure.

“This has been a story that’s been around for quite a while, but it never quite materializes,” he said. “It’s going to be hard getting wages higher: U.S. labor markets are more globalized than they were in the past, and really strong earnings are concentrated in a very few companies. Most companies feel uncomfortable giving wage gains over 1.5%, and many small businesses say they can’t afford to do so because of competitive pressures.”

Ken Goldstein, economist for the Conference Board, agrees.

“The big companies are making money, but it’s the small and mid-cap companies that do most of the hiring. And they’re making money without having to offer more money to job candidates.”

And while low unemployment traditionally pushes inflation higher, the economy has plenty of deflationary winds pushing it, too. Companies like Amazon keep prices low for consumers, but tend to kill jobs in traditional retail stores as well. Globalization is still a deflationary force in the economy.

In addition, the Federal Reserve has taken a more hawkish turn in the past year, raising short-term interest rates and announcing plans to reduce its balance sheet — milquetoast measures, granted, but still an anti-inflationary force.

It may be, like Japan, an aging workforce and slowing economy could mean lower inflation over time. Inflation has already been trending downward, Mr. Lonski noted.

“The past 20 years, inflation has averaged 2.1% a year. The past 10 years, 1.8% a year, and the past five years, 1.3% a year.”

Mike Englund, chief economist for Action Economics, thinks inflation could average 2% in 2018 and could ultimately hit 2.5%. But, he warns, persistently low oil prices could keep the global economy sluggish. Mr. Goldstein agrees with the 2.5% forecast.

“But I doubt we’ll get much higher than that,” he said.

TIPS are one traditional way to hedge inflation risk, and they could also be a nice insurance policy against a spike in oil prices. TIPS returns are based on the consumer price index, which includes food and energy.

In 2008, for example, TIPS funds gained more than 10%, despite the economic downturn. The reason: Oil prices spiked.

“The consensus estimate for inflation next year is a bit over 2%,” Mr. Lonski said.

You’ll get decent returns if the consensus is right, but you won’t be doing a happy dance, particularly if interest rates rise at the same time. TIPS are, after all, still bonds.

And if inflation spikes to 4%?

“You’ll be a happy camper,” he said. “TIPS are still more of an insurance policy than a surefire way to beat the bond market. “

Related Topics: Federal Reserve