Central tendency of inflation is at a 10-year high

August 23, 2019 — In this Q&A, the Eaton Vance floating-rate loan team offers its perspective on today’s loan market.

By: Craig P. Russ; Andrew Sveen, CFA; Ralph Hinckley, CFA; Christopher Remington

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By Stewart D. TaylorInvestment Grade Fixed Income Portfolio Manager, Eaton Vance Management and Jason DesLauriersInvestment Grade Fixed Income Trader, Eaton Vance Management

Boston - Despite the recent weakness in the headline Consumer Price Index (CPI), the central tendency (or middle value) of inflation continues to trend higher. We believe investors focusing on the low inflation rate of the last six months are likely making a mistake.

In a repeat of what has become common behavior since the financial crisis, investors are again discounting the dangers of higher inflation. Three main factors led to the most recent change in perception. The most important was the sharp fourth-quarter decline in crude oil. The inflation base effects associated with this sharp decline resulted in a series of three consecutive unchanged monthly prints in headline CPI. By February, year-over-year (YOY) CPI had fallen to 1.50%, matching the lowest reading since September 2016. The decline pushed market-driven inflation breakevens sharply lower and helped the Federal Reserve (Fed) justify pausing its tightening campaign.

Inflation expectations also fell, as the synchronized global economic expansion became a synchronized slowdown. In the U.S., the Atlanta Federal Reserve's GDPNow quarterly estimate fell as low as 0.70% before recovering back above 2.00% in March. Against this backdrop, YOY headline and core CPI inflation recovered and ended March at +1.90% and +2.00%, respectively. YOY Core Personal Consumption Expenditures (PCE), the Fed's preferred inflation gauge, ended January at +1.78%, modestly below the Fed's 2.00% target.

Inflation Blog Post Image

Removing the noise

Headline CPI can be noisy, particularly during periods when energy or food prices become volatile. This "noise" can obscure the true underlying trend of inflation. To combat this lack of visibility policymakers depend on several alternative measures. The most widely followed of these measures is core CPI. Originally intended as a method to remove one-time shocks to headline CPI associated with food and energy, it has become the markets' favored method of measuring inflation. The problem is that these two sectors comprise 21% of CPI. Focusing on core during periods when food or energy are trending can distort the true underlying trend.

A better way to assess the true underlying inflation rate is to use the median price change of the inflation basket. To compute CPI, the Bureau of Labor Statistics (BLS) calculates and reports the weighted average of all items in the inflation basket. In contrast, the Cleveland Federal Reserve Bank (CFRB) looks at the median price change of all the items in the basket. The median price change then defines inflation's central tendency. CFRB research suggests that this measure has more efficacy in predicting future inflation than the traditional BLS offering of core CPI.

Current CPI central tendency

CFRB YOY median CPI for March was 2.84% versus the 2.00% gain reported by the BLS core CPI. This represents the highest central tendency in underlying inflation in over 10 years. It is notable that 2.84% is only about 0.50% below the peaks set in both 2001 and 2007. The central tendency is marching steadily higher, despite weakness in commodities.

Our near-term outlook

Given the sharp rallies in both commodities and crude oil that have occurred since the beginning of the year and the persistent strength in the cost of services, it is likely the central tendency will continue to move higher. Strength in rents and housing should keep services inflation rising, while rallies in the commodities complex should add support to goods inflation. There is also potential for historic Midwest flooding. Should this impact food costs, a 17% weight in CPI, inflation will likely yield to significant upside pressure.

Our longer-term inflation outlook

It is our view that the decades-long trend of lower inflation that began in the 1980s and accelerated in the era of rapid globalization during the 1990s and 2000s is over. Many of the macro forces that supported the trend, for instance, demographics and globalization, are reversing. There is also significant evidence that wage pressures are building. A good example is the Atlanta Federal Reserve wage growth tracker. This indicator properly adjusts wages for demographic change in the workforce. It is growing at 3.40% YOY and has been solidly above 3.00% since early 2015. Historically, wage growth and inflation are likely to develop in the latter stages of the business cycle. At nearly 10 years old, this recovery is elderly.

More importantly, global central bankers believe that moderate inflation is a good thing and they have the policy tools needed to achieve it. More recently, they have signaled a tolerance for inflation running above their 2% target. This is not the inflation-vigilant Fed of past decades.

How to best hedge inflation

Short-duration TIPS (with maturities inside of five years) and direct inflation assets remain the best vehicles for directly hedging CPI inflation. Five-year inflation breakevens are still below 2%. Given our view, they offer significant value, lower volatility and more safety than most other hedging options.

Bottom line: We think it likely CPI will produce above-average monthly prints over the next few quarters, resulting in strong inflation accruals to Treasury Inflation-Protected Securities (TIPS) and inflation derivatives.

The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness.