Highlights:
• The inflation print for September came in below economists’ consensus, with headline CPI at 2.3 percent year-over-year, and core CPI (excluding volatile food and energy) at 2.2 percent year-over-year, but while commentators will find a reason why that is, this tells us little about the trends in aggregate price change.
• The fact is that while wages have improved at a decent pace, but do not appear to be translating into excessive price increases at a general level, although to be sure inflation is running near the Fed’s target.
• Wage gains are unlikely to result in much higher inflation from here, unless corporate pricing power shifts meaningfully higher, and it is possible that the increasing price of labor instead compresses corporate margins.
• The fact is that the new economy evolving today is replete with technology-driven goods-sector disinflation and that will mean that the neutral rate of interest, and the desire to go much above it, will likely be muted, despite recent comments from the Fed chair.
Each and every month, market commentators will find a reason for why the inflation print has deviated from their expectations, but while this can be a creative exercise, it often tells us little about the cyclical trend in aggregate price change. The fact is that inflation continues to firm, albeit at a fairly moderate pace, and it came in modestly below expectations again last month. Indeed, September’s headline CPI data printed at 0.1 percent, month-over-month, and 2.3 percent year-over-year, and Core CPI (excluding volatile food and energy prices) came in at 0.1 percent month-over-month and 2.2 percent year-over-year, overall below economists’ consensus expectations. Further, the Federal Reserve’s preferred measure of inflation, core PCE, sat at 2.0 percent for the 12-months ending August. As we’ve mentioned in recent comments on labor markets, wages have improved at a decent pace, but do not appear to be translating into price increases at a general level, or at least not yet. In our estimation, wage gains are less likely to result in much higher inflation, unless corporate pricing power shifts meaningfully higher, and it is possible that the increasing price of labor merely compresses corporate margin levels instead, which could become a concern.
There are a few reasons why we’re not excessively concerned about wage increases seeping into the inflation data in an extreme manner, but one is that we think the nature of the economy is evolving in a manner that holds this dynamic in check. For one thing, we think that increased levels of household savings than historically has been witnessed in our formerly goods-dominated economy is likely to mute the transmission of wage gains into generalized inflation. Further, there are powerful secular inflationary headwinds that we have long discussed, such as those related to technology and demographic change, which are likely to continue to exhibit a downward pressure on excessive price rises. Added to that decelerating global growth, and diminished global liquidity, are likely to become increasing concerns for policy makers in the year ahead, and thus we think the Federal Reserve policy reaction function will be more subdued than many in the market anticipate.
Furthermore, the recent rise in bond yields, or effectively the cost of money for borrowing entities, is the “shark closest to the boat” for markets right now, and the degree to which increased wage rates exacerbate this, so policy makers will be keeping a close eye on how these factors translate into tightening financial conditions more broadly. In fact, we are already witnessing some softness in highly rate-sensitive segments of the economy, such as the housing sector, where home price appreciation has slowed somewhat and fewer new homes are being built than previously in the cycle. Auto sales is another area we might expect to see some eventual slowing, as higher rates typically bite with a lag. This should eventually become a topic of greater discussion in policy circles.
We do believe that the Fed’s rate-hiking path will be influenced by the U.S. economy leveling off next year, by global economic conditions (including the U.S. dollar), by tariffs and trade impacts, and by how much inflation actually accelerates in the year ahead. The fact is that the new economy evolving today is replete with technology-driven goods-sector disinflation and that will mean that the neutral rate of interest, and the desire to go much above it, will likely be muted, despite recent comments from the Fed chair that appear to contradict this. So, in our view, the Fed will hike rates in December, but then will probably only tighten a couple of times next year, versus the consensus expectation of three or four hikes in 2019, which we think could be excessive. Markets need to take the broader picture of inflation, financial conditions and the potential for a moderate economic slowing into account, and should stop paying attention to the continual “one-off” explanations for why economists’ estimates of inflation are always just off.
Rick Rieder is BlackRock’s chief investment officer of Global Fixed Income and portfolio manager of BlackRock Strategic Income Opportunities (BSIIX), BlackRock Total Return (MAHQX) and BlackRock Strategic Global Bond (MAWIX).