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Economic Insights

While key measures in the January report came in higher than expected, it shouldn’t raise alarm bells for the U.S. Federal Reserve.

Given the recent market volatility sparked by concerns about U.S. inflation, the January data on consumer prices from the U.S. Bureau of Labor Statistics (BLS) were bound to attract a greater level of scrutiny than the data normally receive. The release of the report on Valentine’s Day did, however, contain a couple of surprises. The headline U.S. Consumer Price Index (CPI) was up 0.5% for the month, compared to a consensus forecast of a 0.3% increase, and the core CPI (which excludes food and energy prices) was up 0.3%, compared to forecasts of a rise of 0.2%. At mid-morning on February 14, investors in U.S. equities seemed to take the news in stride, as evidenced by modest gains in major stock indexes, while Treasury yields moved higher.

While the higher-than-expected January reading for the core CPI was the result of a broadly based set of influences, rather than merely a single anomaly, the new information received on February 14 shouldn’t trigger meaningful upward revisions to inflation forecasts for 2018 and beyond. In addition, a set of BLS technical adjustments introduced with the January release—including a change in the geographic sample and an adjustment for how the CPI for used-vehicle prices is calculated—makes the monthly change from December “noisier” than usual.

What drove the higher-than-expected reading in the core index? The BLS report shows that it was largely attributable to a 0.4% increase in the prices of core goods (commodities, excluding food and energy). While U.S. inflation hawks will tie this back to rising import prices, a more likely explanation is that January price cuts by retailers were less generous than usual after stronger-than-expected holiday sales.

In core services (excluding energy), rent inflation is picking up gradually, in response to fundamental pressure from demand outstripping supply in housing. However, core services prices (excluding rent) still seem to be under pressure, notwithstanding a 0.6% rise in medical care service prices in January and a 1.3% rise in motor-vehicle insurance costs (as per the BLS report), thus continuing the relentless pace of premium increases in recent months.

Fed Implications
What do the data signal for the direction of U.S. Federal Reserve (Fed) policy? The low-inflation dynamic that the U.S. economy has functioned under since the mid-1990s has not yet changed meaningfully, and the policy-setting Federal Open Market Committee (FOMC) likely will reflect this in the forecasts that will be released after the FOMC meeting scheduled for March 20–21. Before that, a slowdown or a downward revision in average hourly earnings in the February employment report (set for release on March 2) should help reassure investors that the trajectory of rate increases and the Fed’s balance-sheet contraction that the Fed previously outlined is still on track.

Even if there are very few indications that inflation has started to accelerate, investors have questioned whether the FOMC will adhere to its plans for gradual rate hikes and balance-sheet contraction in the face of stronger-than-expected U.S. economic growth and increasing fiscal stimulus from both tax cuts and spending increases. Uncertainty about future rates, however, has increased sharply in recent weeks.

If FOMC economic projections continue to show a central tendency for core inflation to rise from only 1.5% in 2017 to 2.0–2.1% in 2020, when the new set of forecasts is released at the FOMC meeting in March, then a reaffirmation of the current rate path—fed funds rates of 2.1%, 2.7%, and 3.1% in 2018, 2019, and 2020, respectively, along with a long-run equilibrium rate estimate of 2.8%—should reduce uncertainty. However, if forecasts for inflation shift upward in response to more aggressive fiscal stimulus, bond yields could rise even further, as expectations about the future rate path and inflation shift higher and reflect a wider range of potential outcomes.

A Final Note
We often are asked about specific portfolio responses to changes in the inflation rate. Investors who are concerned about a meaningful increase in inflation may be considering purchasing Treasury inflation-protected securities (TIPS) as a means of portfolio protection. We would note, however, that TIPS may not be an ideal inflation-protection strategy in a rising interest-rate environment, given their characteristically long duration. An alternative approach—one combining a portfolio of short-term, credit-sensitive bonds with an overlay of CPI swaps—may provide the inflation protection that investors desire without the potential duration risk of TIPS.

 

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The Lord Abbett Inflation Focused Fund seeks to deliver total returns that exceed the rate of inflation in the U.S. over a full inflation cycle. Learn more.

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