Tuesday’s April Consumer Price Index (CPI) report was generally received as providing more evidence that inflation is under control. What many market watchers missed, however, was that core inflation, inflation excluding volatile food and energy prices, is displaying a worrisome trend for both consumers and investors — price creep, or a gradual and almost imperceptible increase in prices.
1.) At 2.31%, April’s core inflation figure was the highest since September 2008.
2.) April was the seventh month in a row in which core inflation was above the Fed’s stated target of 2%.
3.) April’s core inflation reading was nominally above the 20-year average.
To be clear, this doesn’t suggest that alarmist predictions for Weimar-style inflation are about to come true. As I’ve mentioned before, it’s hard to argue that inflation in the United States is about to accelerate in any meaningful way this year. Wage growth is slow, most of the US manufacturing sector is still struggling with excess capacity and up until late last year, the dearth of bank lending prevented any acceleration in the money supply.
That said, while double-digit inflation still looks fanciful, the rise in core inflation shows that prices are slowly creeping up and US consumers and investors are likely accepting, and becoming accustomed to, higher prices and higher valuations without even noticing. In other words, US consumers and investors may be the proverbial frog in the pot of slowly heating cold water and this is only likely to continue.
High unemployment will probably prevent any meaningful acceleration in wages, though the skills mismatch between employees and potential employers may still result in some wage acceleration. In addition, monetary conditions are no longer quite so innocuous when it comes to inflation. Bank lending to businesses – measured by commercial and industrial loan demand – is now rising 13% year over year and is close to a 3 ½-year high. Meanwhile, M2 has been growing at about 10% year over year since last summer. Though it still takes time for growth in the money supply to translate into inflation, the monetary environment is slowly turning.
For investors, there are a couple of implications:
1.) Recognize purchasing power erosion: Even if inflation stabilizes at current levels, over the long term 2.3% inflation would still cause prices to rise by 50% in less than two decades time. In other words, inflation of this magnitude would cause a one-third erosion in purchasing power over the next 18 years. This is an important consideration for investors with large cash positions. And for bond investors – particularly those with large Treasury positions – this is one more reason to question the wisdom of accepting sub-2% yields for the next decade.
2.) Consider equities and commodities: While uncertainty over Europe and Chinese growth are likely to keep volatility high this summer, investors should consider using near-term market weakness to add to long-term equity and commodity positions. To be sure, neither asset class is likely to offer double-digit returns over the long term. However, both may help investors keep their purchasing power from being slowly heated away.