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 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.
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.
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 8 1/2 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 percent 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.
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.
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.
Reference: The Straits Times
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