Kristina Hooper, CFP®, CIMA® is head of investment and client strategies for Allianz Global Investors Distributors LLC. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.
Investors should prepare themselves for higher inflation because the market may be ignoring it—a mistake that could come back to haunt. On the heels of encouraging economic data, central bankers are projecting only modest price increases for goods and services over the next 10 years. But history tells us that an inflation spike is inevitable when governments print money so aggressively.
For now, the market isn’t too concerned about inflation. Stocks hit a five-year high last week, driven by positive reports on housing and labor, as well as the possibility of an extension of the debt ceiling, which relieved some pressure. Adding to the positive news was reassurance that inflation remains in check.
The US Department of Labor released last Wednesday its most recent inflation data. The Consumer Price Index was flat for December, in line with expectations, after a decline of 0.3% in November. Core CPI, which excludes the often-volatile food and energy categories, was up only 0.1% in December. For all of 2012, CPI rose just 1.7%, one of the three smallest increases it has seen in the past decade. And rolling five-year inflation has fallen to an annual rate of 1.9%, marking its lowest level in more than 40 years.
Tame inflation seems surprising given the unprecedented amount of monetary stimulus thrown at the economy since the great financial crisis of 2007-2008. One explanation lies in the severity of the situation: while the stimulus has been dramatic, so was the crisis. In fact, last week’s release of the transcripts from the 2007 FOMC meetings shows the Fed’s growing realization of the enormity of the economic crisis. Janet Yellen was one of the FOMC members to recognize the potential danger. In June 2007, she warned that the housing sector was a “600-pound gorilla in the room.” She added that “the risk for further significant deterioration in the housing market, with house prices falling and mortgage delinquencies rising further, causes me appreciable angst." As we know, the FOMC came to heed those warnings and embarked on a colossal monetary-stimulus effort that continues to this day.
Under 2% Until 2023?
Inflation’s cause is simple: too much money chasing too few goods. And while the amount of money in the economy has increased significantly since the financial crisis began, there hasn’t been as much demand for goods in this relatively weak recovery. In fact, while M2—a broad measure of the US money supply—is at its highest level in more than 30 years, the velocity or rate of turnover of M2 in circulation is at its lowest level in more than 50 years. This suggests that the risk of inflation is still quite low in the near term, despite the massive liquidity that has been injected into the economy.
In fact, inflation is so low in relative terms that it seems to have colored inflation expectations for the longer term. According to the Cleveland Federal Reserve Bank, the latest estimate of 10-year expected inflation is 1.48%. Yes, the market expects the inflation rate to be well below 2% on average over the next decade.
Investors may not be worrying about longer-term inflation, but they should—because central banks may not be. In a speech last week, Minneapolis Fed President Narayana Kocherlatoka urged the Fed to focus its efforts on alleviating unemployment rather than inflation: “… the FOMC can better promote price stability and promote maximum employment, as mandated by Congress, by adopting a more accommodative policy stance. It can provide that extra accommodation by lowering the unemployment rate threshold in its forward guidance to 5.5% from the current setting of 6.5%.”
Moving the Fed away from targeting inflation is dangerous. It will likely drive inflation higher over the long term, putting policymakers at a disadvantage. As soon as investment and money velocity picks up, inflation will take hold so quickly that they likely won’t have time to adequately react.
While we anticipate low inflation over the shorter term, we believe in vigilant monitoring of the inflation picture over the longer term. Typically, large injections of stimulus into economies ultimately result in inflation. As such, investors with long-term time horizons should have substantial exposure to inflation-hedging asset classes. Now, more than ever, real returns matter.
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