Market Watch: The Conversation On Inflation

Given the recent changes in the economy from the tighter labor market, upcoming tax cuts and recently passed two-year budget deal, many of us feel anxious about how our spending will be affected. As the current inflation rate is expected to rise further due to these changes, the prospects of rising inflation have led to several discussions that debate whether we should be excited or nervous for our future spending.

To gauge the effects of inflation, one should understand that the inflation rate represents the rise in the general level of prices for goods and services. As prices increase, the purchasing power, or value of the dollar, goes down. To put it in simple terms, if a product cost just a dollar last year, you’ll have to pay more for it this year at a price one-dollar times the inflation rate.

The inflation rate is measured using the Consumer Price Index (CPI) and the Producer Price Index (PPI), for which the data is reported by the Bureau of Labor Statistics (BLS). Though CPI is the main index used to gauge inflation, PPI is included to have an outlook on where firms are heading in their price changes.

The former index measures the price changes of consumer goods and services while the latter measures the changes in selling prices for those same products. However, the prices of products from the food and energy industries are often influenced by external factors that aren’t pertinent inflation, and are thus excluded from the Federal Reserve Bank’s calculation of the inflation rate.

The Fed is the U.S. central bank responsible for regulating inflation to maintain financial stability by imposing interest rates that work to keep inflation at a desirable level, a suggested 2 percent. By keeping prices stable, the Fed helps firms and households alike make educated guests on what to expect for the future and how to plan their finances around it.

The current inflation rate is reflected in the 2.1 percent increase in prices for all goods in January compared to its 0.1 percent the previous year. As reported by the BLS in their latest releases on CPI data, there was an overall increase in prices across industries except for the automotive and apparel industries. Although the CPI for all items was 2.1 percent, it became 1.8 percent once food and energy prices were removed. The latter percentage is the rate of inflation the Fed is watching in their monitoring of inflation.

As reported in the BLS January job report, the U.S. has sustained its low unemployment rate of 4.1 percent – a record low for the economy from the last 17 years – for the fourth month in a row. Based on this tighter labor market, we expect to see employers increase wages to either lure new hires or incentivize their employees to stay.

According to the same report, production and nonsupervisory employees experienced a 2.4 percent increase in both average hourly earnings ($22.34) and average weekly earnings ($750.62) compared to last year. Thus, even when adjusted for inflation, the majority of those on private nonfarm payrolls still experienced a real wage growth in January.

Furthermore, many states and cities raised their minimum wage for 2018. Of this list, California, New York and Washington were the top three whose state or cities ranked the highest in their minimum wage amount. Tax cuts are also expected to increase workers’ income through their personal taxes and through their employer from either a raise or bonus.

With an increase in their disposable income, employees will want to consume more and increase their spending. Producers will take this increased demand for their products as a sign for them to hike up their prices. However, inflation is already well within the range of the Federal Reserve’s preferred rate. Should prices spike to an unexpected amount, the purchasing power of the dollar will go down further and disrupt the flow of the economy.

While employees see mostly positive aspects of a rise in inflation, investors in the stock market see less advantages from that potential shift in rates. In the past month, the stock market swung erratically as the rates for Treasury bonds increased sharply in a matter of days. The 10-year Treasury note alone has increased to 2.95 percent from its 2.4 percent at the start of the year. However, these increases were mostly due to the $300 billion budget deal passed last month and further government spending that may come from the White House budget proposal and Trump’s infrastructure plan.

Though as stated by S&P Dow Jones Indices Head of U.S. Equities Jodie Gunzberg, "If there is accelerating growth and inflation, like now, rising interest rates can result in appreciating assets." These treasury yields could spark a switch in investor interests as they could potentially give a bigger rate of return if inflation is to rise even higher and call the Fed into action.

According to the minutes from the Fed’s meeting in January, the central bank plans to hike up interest rates three times this year. While this number meets expectations from last year, investors are still worried that those hikes may come sooner than expected. As mentioned before, real wage growth was seen in the first month of the year. Though they officially plan to have three hikes, the Fed stated that they would monitor inflation should it suddenly change and necessitate more responses from them.

Since the start of the new year, we’ve seen moderately increasing stocks experience fluctuations, unemployment rate remains at its lowest and wage growth expected to reach new heights. Although inflation has increased higher than it has before, our economy is still at a relatively safe rate of inflation. Until inflation increases past the Fed’s 2 percent soft spot, causing high increases in interest rates, consumers and investors should remain vigilant in their financial affairs should any unexpected price hikes occur.