Musings on Interest Rates and Inflation

The most important debate by far within the investment community is how much farther interest rates will rise. This debate is critical for investors because low interest rates have been integral to both the steady economic growth and the rapid rise in asset prices (stocks, bonds, real estate, etc.) we have enjoyed for several years. Economists are quite divided on the subject because there many different factors, both short- and long-term, that can cause interest rates to fluctuate. These factors can include everything from unforeseen economic “shocks” to long-term trends that have been firmly established. This is why forecasting the direction of interest rates is such a difficult, if not futile endeavor.

It is important to remember that nominal interest rates consist of two components – the real interest rate and the inflation rate. Real interest rates fluctuate based on the supply of and demand for money, or credit. Generally speaking, credit growth will accelerate (and interest rates will rise) during periods of strong economic expansion, and credit growth will slow or contract (and interest rates will fall) during economic downturns. These relationships between growth and interest rates are not etched in stone, which adds another level of complexity to the challenge of interest-rate forecasting. But all else equal, demand for credit will increase as economic growth accelerates, and vice versa.

The second and more impactful component of nominal interest rates is the inflation rate, which is obviously the rate at which price levels rise. It this side of the equation that has caused the Fed and private economists so much consternation over the last many years. In short, most economists and policymakers had expected a lot more inflation at this stage in the economic recovery. It has taken nine years of ultra-loose monetary policy, large tax cuts for both businesses and individuals, and sizable increases in government spending to finally get inflation to the Fed’s target of 2%. Importantly, though, the relative lack of inflationary pressures has also provided justification for the Fed to maintain highly accommodative monetary policy. And this extended period of accommodative monetary policy has led to rapid inflation in asset prices, huge gains in aggregate household net worth, and an exacerbation of economic inequality.

As a quick digression, we ask if asset inflation should be given more weight by the Fed when setting the course of monetary policy. We have argued that it should. Buying a home and saving for retirement are two of the largest expenses for the average family, and the rising cost of meeting these obligations must be accounted for. Housing inflation needs little explanation; if prices are high and rising, prospective homeowners will have to pay more to buy their home. Higher monthly mortgage payments might deplete savings or crowd out other spending. From an investment perspective, high home prices might result in the homebuyer building home equity at a slower pace, and her potential for capital gains upon sale could diminish. For financial assets like stocks and bonds, the investment implications are similar. If valuation levels rise to unsustainable heights (for example, as measured by P/E ratios for stocks and yields for bonds), we can generally expect future returns to be lower than they might be if we had bought at more attractive valuations. Lower expected returns means we might have to save more, crimping current spending, in order to reach retirement goals. The need to set aside a larger chunk of the monthly paycheck will be a reality for many prospective retirees who have fallen behind in their retirement planning. And this says nothing of the potential for financial bubbles or other crises that could develop as a result of the financial imbalances created by years of “easy money.” Based on these considerations, we firmly believe that asset inflation should be given more weight in the Fed’s assessment of overall inflation. The Fed’s preferred inflation gauges, the PCE deflator and, to a lesser extent, the CPI, do a wholly inadequate job. But I digress.

So, low inflation has been the primary factor keeping interest rates from rising at a faster clip. Still, we have seen a fairly sizeable spike in inflation rates since 2015, and that spike has translated into higher interest rates across the yield curve. In the first two charts below, you will see that inflation, as measured by both PCE and CPI, has accelerated to multiple year highs whether or not we include the prices of food and energy. In fact, it appears as though the Fed has pretty much met its interest-rate target of 2%. This is why the Fed has now embarked, in earnest, on what appears to be a campaign of systematic interest-rate increases in an effort to stave off an overheating economy and runaway inflation.

Source: Bureau of Labor Statistics and Bureau of Economic Analysis.

 

Source: Bureau of Labor Statistics and Bureau of Economic Analysis.

 

It turns out, though, that the path forward for the Fed may not be all that straightforward. The dilemma confronting the Fed and other policymakers is that despite rising inflation and a very low unemployment rate, wage growth has not picked up very much. In the chart below you will again see that inflation, as measured by headline CPI, has accelerated from zero in early 2015 to nearly 3% in the past three months. Over the same time frame, growth in average hourly earnings has only increased from about 2% to 2.7%-2.8%.

Source: Bureau of Labor Statistics.
In the next chart below, the problem becomes more clear. The blue line represents the growth rate in real, or inflation-adjusted, average hourly earnings. The orange line is headline CPI. You can see that inflation has risen to the point whereby it is offsetting all the gains in average hourly earnings. In other words, the paltry 2.7%-2.8% growth in average hourly earnings over the past few months has been barely enough to improve the average consumer’s purchasing power. In fact, the growth rate in real average hourly earnings went negative in July, meaning that the consumer is actually losing purchasing power!
Where does this leave the Fed? It seems to me they’re in a very tough spot. If they continue to raise interest rates, they may be able to contain inflation (as they define it). But doing so could also imperil the modest wage growth we are now seeing. It seems like this course of action would be like cutting off their nose to spite their face. On the other hand, if they decide to pause their rate-hike campaign we could see inflation accelerate even more with no guarantee of better wage growth. Furthermore, under this scenario asset prices and economic growth would likely rise over the short term, threatening to increase the likelihood of financial bubbles and other imbalances. What to do!?!
Source: Bureau of Labor Statistics.
What’s the silver lining when it comes to negative real wage growth? Well, if wage growth stays this weak then corporate profit margins are less likely to be negatively affected by wage pressures. Slack in the labor market has been a boon for corporate profits since the end of the Great Recession. But now it just might be the gift that keeps on giving. The problem, though, is that given the status quo, the fruits of this economic expansion will continue to accrue to a small percentage of the wealthiest among us. We continue to believe that higher and more sustainable rates of economic growth will only be possible if and when the economic benefits become more widely dispersed.
So where does this leave us as investors? We sound like a broken record, but we’re cautiously optimistic. Or perhaps optimistically cautious. While we hope for the best – continued subdued inflation and low interest rates, expansion of corporate earnings, yet somehow enough wage growth to continue pushing the consumer-centric economy forward – we would be delinquent if we did not prepare for a worse outcome. We also recognize the narrowing path for the Fed’s monetary policy to keep the economy in the “Goldilocks zone.” Over the longer term, we do not expect corporate America to produce anywhere near the returns over the next decade as it has over the past ten years. That said, we remain fully invested, confident in the resilience of the American economy, and assured that assiduous research and maintaining a disciplined strategy will help secure our clients’ investment goals in an ever-changing environment.