The likelihood that inflation will continue to rise is driven by a policy shift at the Federal Reserve that is less accommodating and the uncertain fiscal and tax-reform platform of the Trump administration.
The Fed appears to be comfortable with higher inflation and has indicated that it wants to run the economy “hot.” During a mid-October speech in Boston, Federal Reserve Board Chair Janet Yellen spoke about “temporarily running a ‘high-pressure economy,’ with robust aggregate demand and a tight labor market.”
Though Yellen has since backed away from her statement, the Fed is unlikely to implement measures that could kill inflation, such as a rapid series of rate increases. This makes sense given that the Fed believes there are still productivity gains to be made in the U.S. economy and that the market has fallen short of the Fed’s 2% inflation target for some time now.
The uncertain fiscal and tax-reform platform policy positions of the incoming White House team also seem likely to support inflation on the margins. Donald Trump has put forward a set of ideas that may involve higher fiscal deficits, a large infrastructure build-out and protectionist trade policies, all of which could support higher inflation.
The combination of Fed and Trump policies leads us to think the current inflationary trend is likely to continue for some time. Inflation has been so low for so long that it has, to some extent, been ignored as a risk factor. People were resigned to a world of low growth and low inflation. That looks set to change, and you should prepare now to adapt to this dynamic environment.
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The above graph shows four major indicators for determining US economic health. Manufacturing and the non-manufacturing PMIs (purchasing managers’ index) rose in recent months. The rise points to a recovery in those sectors. The recovery in the manufacturing sector is encouraging. Meanwhile, GDP growth seems to have picked up after a sluggish period. Consumption growth remains strong due to solid jobs growth and improving wage growth.
An improving economy suggests that “good inflation” is here to stay. However, the Fed has to ensure that the economy doesn’t overheat. If the Fed waits too long to hike rates, the economy might stall—similar to how a car stalls if you go from first to fourth gear.
In the short term, rising inflation means that you will have to accommodate inflation-resilient assets in your portfolio.