Issue 26: 2014

Beyond The Headlines

Inflation

An Interview with DeAnne Steele

Photograph by Andy Ryan

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In this issue, we interview DeAnne Steele, investment executive for the western United States at U.S. Trust, who tackles some common questions about inflation, the rationales behind its various measures, and the ways it impacts the economy, interest rates and — most important — our own investment portfolios.

What are the measures of inflation, and which ones
are most important? How
do we interpret them?

The two main measures of inflation are the Consumer Price Index (CPI) and the Personal Consumption Expenditures (PCE) price index. The CPI and PCE index both track changes in the prices of consumer goods and services, and the core versions of both remove food and energy prices. The PCE tracks more business goods and services, and tends to rise about one-third of a percentage point less than the CPI, as it assumes the consumer will substitute goods with rising prices for goods with stable or falling prices. As an important indicator, the Federal Reserve has indicated that it prefers the PCE.

Are there other measures of inflation?

The Producer Price Index (PPI) measures the average changes in prices received by domestic producers for their output and the five-year breakeven in Treasury inflation-protected securities (TIPS). And there is the Employment Cost Index (ECI), which tracks changes in labor costs for businesses. Both are important, broader indicators of inflationary pressure; right now, they are showing inflation below the Fed’s target of 2%. Some of their components vary significantly from the larger average, such as medical care and apparel.

Why do the CPI and PCE strip out
food and energy — two things we all need?

It is important to understand who is using these indices and for what purposes. The Fed uses them to understand underlying inflation trends. Food and energy can be very volatile, affected by things such as weather and supply disruption (see “CPI vs. CPI for Energy,” below). As a result, including food and energy prices in interest-rate decisions can mask the underlying economic and inflation trends, and could even lead to controversial monetary policy decisions, such as the European Union’s decision to raise rates in 2011, when oil prices spiked. Although inflation readings picked up due to the oil price increase, the underlying economic trends were not inflationary, and the decision helped them fall into a double-dip recession.

On the other hand, for Social Security recipients relying on CPI to boost their payments, not tracking food and energy can be painful when food and energy prices rise.

 

Given low interest rates and quantitative easing,
should inflation be heating up now?

If all this money pumping into the system made it to businesses and individuals, it certainly would create inflation. However, it does not.

Measuring the frequency at which one unit of currency is used to purchase goods and services is called the velocity of money. As you see in the Velocity of Money chart below, the velocity has been slowing, meaning fewer transactions are occurring between individuals, so less money is circulating.

As velocity of money improves,
will it lead to runaway inflation?

We do not see that occurring. First, the Fed can reduce the stimulus by continuing to taper asset purchases, raising short-term interest rates and increasing the interest rate it pays to banks on reserves. All of these tools reduce the supply of money. Also, demographic trends of an aging population and more strict lending standards should keep demand at a level where inflation remains in check.

Is a little inflation good?

Certainly. Deflation can be much more destructive, as it does not provide an incentive for consumers to buy and businesses to borrow and expand, as we saw for decades in Japan. The Fed’s reflationary policy has helped us to avoid a deflationary spiral and has brought nominal GDP into the range of 4%–6%. This is an ideal level, as deflation and inflation risks are minimal.

What does this mean for interest rates?

We do expect interest rates to rise, although more on the shorter end of the flattening yield curve than on the longer end. We expect to see average nominal rates of about 2.5% for shorter-term yields and 3.5% for 10-year Treasuries over the next couple of business cycles. Wage inflation could pick up sooner than expected given declines in the unemployment rate, requiring the Fed to raise rates sooner than anticipated.

What does this mean for portfolios?

Wage inflation creates the need for better productivity. This is why technology is one of our favorite sectors. In fact, we saw productivity rising in the fourth quarter of 2013.

Also, continued growth and higher inflation should lead to higher interest rates, which will affect bond portfolios, so having an actively managed bond portfolio with a shorter-duration profile may help to protect capital. And, nominal growth in the 4%–6% range is positive for equities, so we remain overweight in equities.

IMPORTANT INFORMATION

Investing involves risk. There is always the potential of losing money when you invest in securities.

Projections made may not come to pass due to market conditions and fluctuations.

Past performance is no guarantee of future results. Diversification does not ensure a profit or protect against loss in declining markets.

Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.

OTHER IMPORTANT INFORMATION

Equities
Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.

Fixed Income
Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments, and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices generally drop, and vice versa.

Treasury bills are less volatile than longer-term fixed-income securities and are guaranteed as to timely payment of principal and interest by the U.S. government.

Unlike conventional bonds, the principal or interest of inflation-linked securities is adjusted periodically to a specified rate of inflation. For example, the principal amount of Treasury Inflation-Protected Securities (TIPS) is adjusted periodically using the Consumer Price Index for all Urban Consumers (CPI-U). Inflation-linked securities of foreign issuers are generally indexed to the inflation rates in their respective economies.

International Investing
International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards, and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.

In this issue, we interview DeAnne Steele, investment executive for the western United States at U.S. Trust, who tackles some common questions about inflation, the rationales behind its various measures, and the ways it impacts the economy, interest rates and — most important — our own investment portfolios.

What are the measures of inflation, and which ones are most important?
How do we interpret them?

The two main measures of inflation are the Consumer Price Index (CPI) and the Personal Consumption Expenditures (PCE) price index. The CPI and PCE index both track changes in the prices of consumer goods and services, and the core versions of both remove food and energy prices. The PCE tracks more business goods and services, and tends to rise about one-third of a percentage point less than the CPI, as it assumes the consumer will substitute goods with rising prices for goods with stable or falling prices. As an important indicator, the Federal Reserve has indicated that it prefers the PCE.

Are there other measures of inflation?

The Producer Price Index (PPI) measures the average changes in prices received by domestic producers for their output and the five-year breakeven in Treasury inflation-protected securities (TIPS). And there is the Employment Cost Index (ECI), which tracks changes in labor costs for businesses. Both are important, broader indicators of inflationary pressure; right now, they are showing inflation below the Fed’s target of 2%. Some of their components vary significantly from the larger average, such as medical care and apparel.

Why do the CPI and PCE strip out
food and energy — two things we all need?

It is important to understand who is using these indices and for what purposes. The Fed uses them to understand underlying inflation trends. Food and energy can be very volatile, affected by things such as weather and supply disruption (see “CPI vs. CPI for Energy,” below). As a result, including food and energy prices in interest-rate decisions can mask the underlying economic and inflation trends, and could even lead to controversial monetary policy decisions, such as the European Union’s decision to raise rates in 2011, when oil prices spiked. Although inflation readings picked up due to the oil price increase, the underlying economic trends were not inflationary, and the decision helped them fall into a double-dip recession.

On the other hand, for Social Security recipients relying on CPI to boost their payments, not tracking food and energy can be painful when food and energy prices rise.


U.S. Trust

Given low interest rates and quantitative easing,
should inflation be heating up now?

If all this money pumping into the system made it to businesses and individuals, it certainly would create inflation. However, it does not.

Measuring the frequency at which one unit of currency is used to purchase goods and services is called the velocity of money. As you see in the Velocity of Money chart below, the velocity has been slowing, meaning fewer transactions are occurring between individuals, so less money is circulating.

As velocity of money improves,
will it lead to runaway inflation?

We do not see that occurring. First, the Fed can reduce the stimulus by continuing to taper asset purchases, raising short-term interest rates and increasing the interest rate it pays to banks on reserves. All of these tools reduce the supply of money. Also, demographic trends of an aging population and more strict lending standards should keep demand at a level where inflation remains in check.

Is a little inflation good?

Certainly. Deflation can be much more destructive, as it does not provide an incentive for consumers to buy and businesses to borrow and expand, as we saw for decades in Japan. The Fed’s reflationary policy has helped us to avoid a deflationary spiral and has brought nominal GDP into the range of 4%–6%. This is an ideal level, as deflation and inflation risks are minimal.

What does this mean for interest rates?

We do expect interest rates to rise, although more on the shorter end of the flattening yield curve than on the longer end. We expect to see average nominal rates of about 2.5% for shorter-term yields and 3.5% for 10-year Treasuries over the next couple of business cycles. Wage inflation could pick up sooner than expected given declines in the unemployment rate, requiring the Fed to raise rates sooner than anticipated.

What does this mean for portfolios?

Wage inflation creates the need for better productivity. This is why technology is one of our favorite sectors. In fact, we saw productivity rising in the fourth quarter of 2013.

Also, continued growth and higher inflation should lead to higher interest rates, which will affect bond portfolios, so having an actively managed bond portfolio with a shorter-duration profile may help to protect capital. And, nominal growth in the 4%–6% range is positive for equities, so we remain overweight in equities.