US financial markets have been roiled recently by something neither the economy nor investors have had to contend with for the better part of a decade: concerns they may soon have to reckon with rising inflation.
What exactly is inflation, aside from a rise in prices for goods and services, and why is it having such a strong influence on markets?
Inflation is measured in a number of ways by various government agencies, and as long as the economy continues to expand, it will be a consideration for markets. Investors would have seen the latest US inflation data yesterday with the monthly Producer Price Index.
1 WHAT IS INFLATION AND HOW IS IT MEASURED?
While inflation decreases consumer purchasing power, a certain level of inflation is considered a reflection of a strengthening economy and the impact on consumers can be offset by rising wages.
The US government publishes several inflation measures on a monthly and quarterly basis. The main measures are the Consumer Price Index (CPI) and the personal consumption expenditures (PCE) price indexes. The CPI and PCE are constructed differently and perform differently over time.
The monthly CPI, compiled by the Labour Department's Bureau of Labour Statistics (BLS), measures the change in prices paid by consumers for goods and services. The BLS data is based on spending patterns of consumers and wage earners, although it excludes rural residents and members of the armed forces. CPI measures the prices that consumers pay for frequently purchased items. The components are weighted to reflect their relative importance, with the weightings derived from household surveys.
Some of the components of the CPI basket such as food and energy can be volatile. Stripping out food and energy from the CPI gives us the core CPI, seen as a measure of the underlying inflation trend.
The January reading on consumer prices released on Wednesday showed prices rose more than expected, up 0.5 per cent versus the 0.3 per cent expectation. The core reading rose 0.3 per cent against the 0.2 per cent forecast. Both numbers increased from the 0.2 per cent reading for December.
Another reading is the Producer Price Index, which measures prices from the seller's point of view. The Federal Reserve, whose mandate includes price stability along with maximum employment, prefers the PCE price indexes constructed by the Commerce Department's Bureau of Economic Analysis (BEA). PCE is considered to be more comprehensive because it includes some components that are excluded from the CPI. According to the BEA, the PCE reflects the price of expenditures made by and on behalf of households. Weights are derived from business surveys.
Housing has a greater weighting in the CPI than in the PCE indexes. The weighting for medical care is greater in the PCE than in the CPI. As with CPI, food and energy components of the PCE are volatile. Stripping them out yields the core PCE, which measures the underlying inflation trend. The core PCE is the Fed's preferred measure for its 2 per cent inflation target.
2 WHAT SPARKED THE RECENT INFLATION WORRY?
The government's monthly job report for January, released on Feb 2, showed wages posted their largest annual gain in more than 81/2 years, suggesting the economy was moving closer to full employment and inflation was on the horizon.
If the economy continues to gain momentum, inflation is likely to rise further towards the Fed's 2 per cent target. There is concern, however, that the recent US tax overhaul by the Trump administration, which slashed the corporate income tax rate and cut personal income tax rates, could cause an economy that may be nearing full capacity to overheat and prompt the Fed to become more aggressive than anticipated in its course of interest rate hikes.
Markets are pricing in an 87.5 per cent chance of a quarter-point increase at the US central bank's next policy meeting in March. The Fed has forecast three hikes this year, after raising rates three times in 2017.
Some market participants are unsure about how swiftly the Fed will react to inflation and market turbulence under new chairman Jerome Powell. The March meeting will be the first since he took over from Dr Janet Yellen. Recent comments from Fed officials suggested the possibility of more hikes should the economy continue to strengthen.
3 HOW HAS INFLATION AFFECTED MARKETS?
Many analysts believe the stock market was overdue for a pullback because valuations, as measured against corporate earnings, have been rich by historic standards, and that the jobs data showed economic fundamentals underpinning stocks are strong. Inflation has yet to rise to concerning levels, and as long as the pace remains modest, stocks have room to climb. Healthy economic growth, along with US deficit spending and moves by global central banks to lift interest rates from ultra-low levels, has driven US bond yields to a four-year high.
Rising yields could dent the attractiveness of high dividend-paying stocks to investors and trigger increased borrowing costs for US companies and households, which could crimp economic growth.
The initial reaction to the CPI data on Wednesday was sharp, with S&P 500 e-mini futures falling to a session low of 2,627 while yields on the benchmark US 10-year note rose as high as 2.891 per cent. The dollar initially spiked higher against a basket of major currencies before weakening. However, stocks recovered and turned positive shortly after the opening bell and yields on the 10-year note eased.
A strengthening currency would normally go hand in hand with an improving economy, yet the US dollar is near four-year lows even after a recent uptick. Some of the weakness has been attributed to anticipation of the scaling back of stimulus measures by central banks other than the Fed. If the US economy fails to show any meaningful uptick in inflation as currently feared, that could tie the Fed's hands when it comes to interest rate hikes and drag the dollar lower.