Tuesday, May 11, 2021
Inflation is one of the primary risks to bondholders. Rising consumer prices erodes the “real” value of principal and interest payments making them worth less. However, the Federal Reserve’s (Fed) reaction to increasing consumer prices could be a risk to bond prices as well. We answer questions surrounding the mechanics around measuring inflation and what we think the Fed’s reaction to rising inflation will be.
How is inflation measured? There is no great way to capture all the price changes in an economy but there are two main indexes used to measure inflation—the Consumer Price Index (CPI) and the Personal Consumption Expenditure Index (PCE), which is the Fed’s preferred index. While both indexes attempt to measure the price changes of a basket of goods, there are some differences between the two indexes. First, the weights to the underlying categories are slightly different. As of the most recent publishing, goods excluding food and energy represented 35% of the PCE index versus 38% for core CPI and the weight for services is slightly different as well (65% for core PCE and 62% for core CPI). There are additional differences at the sub-category level as well including: Owners’ Equivalent Rent (30% of core CPI and 13% of core PCE), Medical Care Services (9% of core CPI and 19% of core PCE) and Transportation Services (6% of core CPI and 3% of core PCE).
Additionally, core PCE makes adjustments based upon expected consumer behavior. That is, as prices rise on a good or service, the PCE index will swap out that good or service for a comparable one with a lower price. This biases prices lower in PCE inflation. Due to the differences between the two indexes, core PCE has generally been 0.25% lower than core CPI, on average.
What has kept core PCE under the Fed’s 2% target? As seen in the LPL Research Chart of the Day, the main reason we haven’t seen core inflation levels (orange line) above 2% has been the consistently lower prices within the goods sector (blue line). Due to things like price discovery and labor substitution, prices for goods have actually declined over time. (See our April 1st blog post reasons why inflation has been contained over time and why we think it will likely be contained going forward.) Service prices (yellow line) have remained fairly stable—so for core PCE to exceed 2% for a meaningful period of time, the prices of consumer goods would have to consistently increase, all else being equal. In particular goods prices for food and beverages consumed offsite (8% of the index), motor vehicles and parts (4.5% of the index), and recreational goods and vehicles (4% of the index) would need to see sustained price increases.
What will the Fed’s reaction be to higher consumer prices? The Fed wants core price increases to average 2% over time. Since core inflation levels have been below 2% for years, they want inflation levels to remain above 2% for “some time” so that price increases average 2% year-over-year. Moreover, they have stated that they will continue to provide monetary support to the economy until “substantial further progress” has been made toward the committee’s maximum employment and price stability goals.
There is a risk to this new approach though. If inflation isn’t transitory and consumer prices continue to increase more than that 2% year-over-year level, the Fed would likely have to react sooner and potentially raise short-term interest rates higher than the markets are expecting. Right now, we don’t believe that to be an imminent risk, but a risk nonetheless.
“We should see higher inflation levels over the next few months but we don’t think it will force the Fed to react before they’re ready to,” according to LPL Financial Fixed Income Strategist Lawrence Gillum. “We think they’re on hold for some time.”
Our base case is that most of the inflation we’re likely to see this year will be transitory and the Fed can take its time before normalizing monetary policy. As such, we believe the Fed will continue with their asset purchase plan throughout 2021 and start to incrementally scale back purchases in 2022. Further, we expect the Fed to begin to raise short-term interest rates towards the second half of 2023. In the meantime, we do expect additional volatility in the bond market but, barring a policy misstep, we don’t see 10-year Treasury yields increasing meaningfully beyond our 1.75% to 2.00% year-end target.
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