Unrealistic Expectations: Could Inflation Start Rising?
It Might Be Time to Favor TIPS
Looking at this from an economic perspective also seems to indicate that today’s inflation expectations may be unrealistically low. My preferred leading economic indicator—the Chicago Fed National Activity Index (or CFNAI)—suggests that current estimates for U.S. inflation appear roughly 40 basis points too low.
While I don’t envision a significant surge in inflation anytime soon, I do expect to see some stabilization in inflation and inflation expectations given factors including declining slack in the labor market. In addition, U.S. inflation should firm as the one-off impact of a stronger dollar and lower energy prices start to fade from CPI calculations.
In the meantime, today’s TIPS prices tell me that investors’ inflation expectations may be too sanguine. As such, in bond portfolios, I prefer TIPS to plain-vanilla Treasuries (TLT). An allocation to TIPS could help hedge the risk that inflation may be on the rise.
Market Realist – Could inflation begin to rise?
The graph above compares how inflation reacted to the last precipitous fall in oil prices during the financial crisis. Crude oil prices fell from ~$140 per barrel to ~$40 per barrel in a matter of months. Inflation spiraled down as well. Since inflation rates show year-over-year changes, oil prices in the base year will eventually fall. For example, inflation rates started picking up after July 2009. This is partly because oil prices were already in the process of declining in July 2008.
Similarly, oil (USO) prices fell from ~$115 in August 2014 to ~$55 in November 2014. So the one-off impact of lower oil prices might begin to fade off from CPI very soon.
In that case, regular bond (AGG)(BND) yields could rise—meaning TIPS (TIP)(ILB) could be a good addition to your portfolio right now if you don’t have them already. While inflation is unlikely to increase meaningfully, TIPS could provide some protection in the short term.
Besides, there are signs of wages and consumption picking up. The last two employment reports have shown that wage rates might finally begin to rise while consumption grew by more than 3% on an annualized basis in 3Q15. If both these trends were to continue, inflation could edge higher.
Read Is It Time to ‘Buy Inflation’? for more on why this could be a good time to buy TIPS.
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