Vanguard experts reveal if investors should soon be worrying about rising inflation once again.
Lara de la Iglesia: Hi, I’m Lara de la Iglesia. Entering 2017, rising inflation was top of mind for many of the world’s central bankers. But more recently, inflation in key markets, like the U.S. and Europe, has shown signs of decelerating, and that’s perplexing forecasts on future interest rate hikes. So to get a clearer picture, I’m joined today by Roger Aliaga-Díaz, Vanguard’s chief economist for the Americas, and Gemma Wright-Casparius, a senior portfolio manager in Vanguard’s fixed income group.
Thank you both for being here.
Roger Aliaga-Díaz: Thank you, Lara.
Gemma Wright-Casparius: Thank you.
Lara de la Iglesia: Okay, so let’s start with Vanguard’s views on inflation. Roger, we outlined our forecast in the Vanguard market and economic outlook in December. Share with us what has changed since then.
Roger Aliaga-Díaz: The inflation readings since March of this year have been a little bit disappointing compared to what we were expecting coming into the year. In general, in our market and economic outlook, we have outlined a scenario in which for developed markets, the U.S. and other countries, it will be difficult to, or challenging to get close to this 2% target that most central banks have an inflation objective based on secular forces—based on technology, and technology lowering the cost of input in production, based on globalization.
But one thing that we did expect was that the tightening of the labor markets that is happening not just in the U.S.—really, across the world—would start creating a little bit more of inflationary pressures, price pressures, and wage inflation—very welcome wage inflation at this point in the U.S.—and that has not happened. And, in fact, since March, actually, we have seen the inflation rates rolling over and actually declining. So that has been a little bit puzzling for us, especially as we see the global market continue improving—has been puzzling for the Fed, actually, and it’s something we’re watching as we go forward.
Lara de la Iglesia: So, Gemma, what’s your view on what’s behind the weak readings then?
Gemma Wright-Casparius: So we were a little bit surprised by the rollover in the cyclical numbers in the end of the first quarter and into the second quarter, mainly because global growth has resynchronized and you’re seeing a tremendous amount of stimulus flow through. Growth numbers are sort of exceeding expectations to the upside.
I think our view was that both the Fed surprising with a rate hike in March, which the market had not been forecasting, and China tightening policy against some imbalances in the economy slowed consumption in the second quarter. So we saw things like auto sales, which had been growing over 18 million units a year, slow down to high-16 million units. Still a great number. Consumers still consuming, but just a little bit of slowdown.
So some of those trend numbers that we like to look at to see if the underlying trend of inflation is steady to higher are still pointing up, and we think that’s important for policymakers going forward. And it’s true not only in the United States, but in Japan and in Europe, where core inflation numbers and metrics are still pointing up.
Lara de la Iglesia: Okay. So let me ask, then, what does this somewhat unclear picture on inflation mean for future rate hikes?
Roger Aliaga-Díaz: The point of view of the Fed is basically, these are transitory factors, transitory effects that will dissipate in a year’s time. Perhaps the Fed had expected early in the year to achieve the inflation target at the end of 2017, early 2018, maybe. Now they have to push that expectation more toward 2018, 2019, and that may decelerate or basically reduce gradually the plans for future rate hikes. But the Federal Reserve is still thinking that these are transitory effects and because of that, at some point, a little bit more tightening will be warranted as the labor market continues basically to increase in terms of employment and decrease in terms of the unemployment rate.
Gemma Wright-Casparius: Our view is the Fed—as Chair Yellen’s indicated—that policy is getting close to normal. So personal consumption expenditures, which is the Fed’s preferred measure, is 1.5%. The fed funds rate is 1.25%. So, clearly, the Fed would still like to raise the fed funds rate at least one more time this year.
Our view in the Fixed Income Group is that they may not have an opportunity to do that. We expect inflation to be slow, sticky, rising slowing and steadily, but the Fed’s balance sheet unwind should begin sometime in September. And we think the Fed would prefer to do no harm to financial conditions, if you will, by starting one series of unwinds—small, gradual, let it build. Take a quarter or two to assess and then come back again and revisit rate hikes sometime at the end of either the first quarter of 2018 or the second quarter of 2018. And so we’re a bit more benign and the market is priced that way as well. the market has a very low probability of another interest rate hike in 2017.
Lara de la Iglesia: Okay, great. Thank you both very much. The perspective is extremely helpful as we watch what happens as the Fed is balancing their targets and monetary policy.
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