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Fixed-Income Insights

If lower inflation is more persistent than transitory, the U.S. Federal Reserve may raise interest rates more slowly.  

As we enter our ninth year of U.S. economic expansion, many by now would have expected late-cycle inflation, aggressive central-bank tightening in response to that inflation, and the associated onset of economic restraint. None of these conditions seem visible, least of all inflation. In fact, to the surprise and consternation of the U.S. Federal Reserve (Fed), inflation has not only failed to meet the Fed’s target of 2.0%, but has been recently falling further away. While Fed members initially characterized inflation declines as transitory, recent comments suggest that the movement may be more sustainable. Whether recent disinflationary trends are temporary or more structural has important consequences affecting Fed policy, interest rates, and economic growth.

Recent Trends in Inflation
The June U.S. Consumer Price Index (CPI) decelerated for the fourth consecutive month to 1.6% year over year. This compares to 2.7% year over year as recently as February. Even the core CPI, excluding food and energy, was 1.7% year over year, the lowest since May 2015. The Fed has generally characterized declines in inflation as transitory. For instance, Fed chairperson Janet Yellen cited a 7% unannualized decline in cell phone charges in March as an example of the potential transitory nature of some disinflationary effects. Major oil price adjustments may be another transitory example, assuming an outcome of price stability as supply and demand rebalance.

But price weakness is not limited to one or two categories. Analysis of the weakness in CPI reveals that over the past six months many categories have witnessed average year-over-year price declines, including televisions, toys, personal computers, appliances, computer software, sporting goods, and even pets and related food and products. Prescription drug prices recovered in June but are up less than 0.5% over the past 12 months.

Such broad-based persistence of lower prices suggests influences that may be more than transitory. Those influences are often technology-driven events that have a sustainable impact on prices. Online shopping has provided accessible and visible lowest-price comparisons, reducing merchandise and service prices directly and indirectly. Healthcare services have made prescription drugs available in a similar manner, effectively reducing co-pays. Uber and Lyft have dampened transportation costs. Airbnb and Vacation Rental by Owner (VRBO) offer less expensive options than many hotels or resorts. Autonomous vehicles and drones suggest technology-driven price pressures are not likely to end soon. Such effects on pricing may be long lasting as they roll out slowly throughout the economy. It may be difficult, if not impossible, to model the price impact of such developments, but the pace of innovation is unlikely to slow.

Persistent vs. Transitory Inflation Effects
Yellen’s recent Congressional testimony gave the first indication that the Fed may now be considering the possibility that lower inflation may be more persistent than transitory. Such a distinction affects monetary policy as, according to Yellen and The New York Times, “persistent weakness could lead the Fed to raise interest rates more slowly.” This implies a willingness at the Fed to await inflation announcements to determine the course of policy. In other words, a delay in rising inflation could delay the Fed’s next rate hike. A resumption of inflation may suggest transitional effects have run their course and rate normalization can continue.

Even if the broad-based deceleration we have seen is transitory, it will take time to reverse recent movements and get inflation back toward the Fed’s target of 2.0%. The task may be even more difficult considering the Fed’s preferred measure of inflation, personal consumption expenditures (PCE), has even more ground to recover than CPI. The most recent readings for PCE and core PCE were each 1.4%. Even if inflation started to rise next month, a September rate hike seems unlikely. A failure of inflation to move higher over the next several months could postpone the next Fed rate hike to 2018.

Wage Inflation
While it may be difficult to differentiate between transitory and more sustainable influences on inflation, the Fed’s true benchmark for frustration must be wage inflation. The inverse relationship between unemployment and wage increases, known as the Phillips Curve, seems to be useless in the current environment. Although cited often by Yellen, and referred to by her as part of a forecasting model for core inflation, the purported relationship has failed to materialize this cycle.  According to U.S. Bureau of Labor Statistics (BLS), unemployment has declined from 10% in 2009 to 4.4% in mid-2017, producing recent wage growth of only 2.5% year over year. Past cycles produced much higher wage growth. When we were last at 4.4% unemployment in 2007 and 2001 wage growth exceeded 4.0% in each case, the BLS reports. Yellen and other Fed members recognize other inputs to wage growth, particularly economic growth and inflation expectations, but they must remain somewhat confounded that stimulative monetary policy that contributed to continued job growth in a full-employment economy has so far failed to push wages meaningfully higher.

Other U.S. labor-market indicators are also consistent with strong growth and more meaningful wage gains. The May quits rate, or willingness of workers to voluntarily leave their jobs, most likely for better positions, accounted for 3.2 million workers, according to the BLS, which notes that this was higher than levels during 2006 and 2007 and the highest level since 2001. The applicants-to-jobs available ratio is another indication of tightness in the labor force, the BLS adds. As the number of job applicants decline, employers may be forced to pay more to hire qualified workers. Once again, not this cycle.  The applicants-to-jobs ratio, which reached 6.6:1 in 2009, is now down to 1.2:1, lower than levels reached in 2006 and 2007. Today’s modest wage gains do not reflect their historical correlation with a decline in available workers.   

Perhaps the key difference between today, when wage gains are surprisingly modest, and past full employment periods when wage gains exceeded 4.0%, is economic growth. Nominal economic growth is much less today than it was in past cycles, potentially reducing labor’s wage demands and reducing business’s willingness to pay more for labor. Nominal economic growth in the three years prior to 2017 averaged 3.5% compared to 6.0% for the three years prior to each of the past periods of 2001 and 2007 when unemployment was comparable to today yet wage growth exceeded 4.0%.

Continued real U.S. gross domestic product (GDP) growth of around 2.0% may not be enough to move wage growth or inflation meaningfully higher. The Fed may be faced with a difficult task of normalizing rates and normalizing its balance sheet in an environment where the central bank falls short of its price-stability objective of 2% inflation. Yet wage and price pressures could still develop, and quickly. The Trump administration’s policies of “buy American, hire American” could produce marginal demand for both goods and labor to push prices higher. Any progress on immigration reform, tax reform, or infrastructure spending could also have a similar effect. Even growth elsewhere in the world may be sufficient to increase marginal demand and related prices. It seems that slight improvement in economic growth, demand for workers, or demand for goods or services could produce the increase in inflation that the Fed and others have been expecting. Until then, it seems the Fed’s path toward rate normalization will be slow and reluctant.

 

The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

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