The U.S. may see inflation of over 2 percent at some time in 2016. The U.S. Federal Reserve has set 2 percent as the rate of inflation that they would prefer to see in the U.S. An inflation rate above 2 percent will banish the specter of deflation which has been a problem for the world over the last few years.
Why do we think inflation will appear in 2016?
We recently analyzed the rate of change in prices of the components that make up the CPI (consumer price index) for the U.S. We noticed that over half of the important variables are up in price over 2 percent in the last 12 months. Additionally, there are many other prices that have lapped or soon will lap their year-ago price declines -- which will change the base and thus increase the reported inflation rate.
Here is a list of some of the changes in inflation rate of over 2 percent in the last 12 months. Together, their weighting in the CPI model that the U.S. Bureau of Labor Statistics uses to compute the CPI is over 55 percent. The items in the following partial list are up between 2.1 percent and 4.7 percent in the past year.
- food away from home;
- other foods;
- medical care commodities;
- prescription drugs;
- hospital services;
- health insurance;
- newspapers and magazines;
- educational books;
- shelter;
- water;
- sewer;
- trash;
- tuition;
- landline telephone;
- motor vehicle fees;
- personal services
- parking fees;
- motor vehicle insurance;
and many others.
Many other components are lapping large declines in price, and the base is lower -- so price increases will soon be seen in the other 45 percent of the CPI basket as well. We see the combination of these events as strong evidence that U.S. CPI will be above 2 percent in 2016. So in 2016, the Fed will be faced with a CPI that is above their target rate. Will they tolerate this or will they act to raise interest rates to combat it?
We see the Fed raising interest rates more than once; perhaps a total of 3 to 4 Fed rate increases from late 2015 to 2016.
Inflation Abroad
Brazil, Venezuela, Argentina and many other countries have been faced with high inflation due to economic mismanagement, corruption, or both. Many other countries that have been better-managed have seen their currencies fall against the US dollar during the last 4 years. Since all of the countries whose currencies have depreciated import goods, the cost of their imports are rising as their currency falls in value. We will not be surprised to see this affect inflation in much of the world. Let us be clear: we a do not anticipate a high inflation rate. We expect 2 percent or more, but we do believe that the threat of deflation will definitely moderate.
Investment implications: The overall Consumer Price Index may still look tame, but an examination of its components shows that more than half are already rising at a rate above the Fed’s 2 percent inflation target. Big commodity price declines are now being lapped, providing a lower base as we move into next year, so the rest of the basket will soon follow suit. We think stronger-than-expected inflation in 2016 could lead the Fed to hike rates three to four times.