But something else stood out in the Fed’s statement: the many references to inflation, which emphasized the central bank’s concerns about the lack of healthy price growth. Inflation is a classic Goldilocks dilemma. You don’t want too much, or too little, but just the right amount. Inflation is something that those of us in the investment community have been talking about for a while now. While some economists worry that the easy monetary policy of recent years will eventually lead to significant inflation, it is possible that too little inflation is on the horizon, not too much.
Market Realist –
The Goldilocks dilemma: Inflation needs to be just the right amount
Who ever thought that US economics could actually be an allegory of a much-loved fairy tale? The Goldilocks dilemma for inflation is all too real. Too much inflation may have a regressive effect on lower income families, while the higher cost of obtaining funds may impede growth of the economy.
With inflation too low, the economy faces the risk of falling wage rates, a freeze on consumer spending (XLY), and the perils of outright deflation. We’ll look more at the risks of low inflation in the last part of the series. Economists often believe an inflation rate of 2%–3% is healthy for an economy. It’s for this reason that the persistently low levels of inflation have been a cause of concern for most US economists.
Inflation is low despite a strengthening labor market
Another curious phenomenon has befuddled the US economy. Usually a rise in hiring and a fall in the unemployment rate is accompanied by a rise in wages and, ultimately, a rise in inflation. However, despite increasing employment in the US economy, inflation continues to stay low.
Market Realist – December saw an addition of 252,000 jobs in US non-farm payrolls, as you can see in the above graph. This made 2014 the best year for hiring in almost 14 years. The unemployment rate fell to 5.6% from 5.8% in November. The unemployment figures are now in touching distance of the Fed’s target range of 5.2 to 5.5%, which you can see in the graph below.
Market Realist – Despite the improvement in hiring and employment, average hourly wages declined by 0.2% to $24.57 in December 2014. This is the first time wages have declined since July 2013. Inflation also continues to stay entrenched around 1.4% despite the improving labor market prospects.
Low inflation tends to hurt gold prices (IAU) (GLD) since historically gold and inflation are positively correlated. Gold prices may in turn affect gold ETFs and gold miner stocks (GDX). Silver (SLV), which is also used often as a hedge against rising inflation, is prone to be affected by low inflation.
Read on to the next part of the series to understand why inflation continues to stay low despite a strong labor market.