Fixed Income

Firming Inflation Gives TIPS Some Upside Potential Despite Hawkish Fed

November 21, 2017
We expect inflation to reach 2% or higher in 2018 as a result of continuing solid growth in the broader economy and a tightening labor market.

Key Points

  • We believe that the sub-2% annualized consumer price index readings we saw during the summer represented a low for the current inflation cycle, and we expect inflation rates will stabilize or run moderately higher in the near term, followed by 2%—or higher—inflation in 2018.
  • U.S. Treasury inflation protected securities (TIPS) have yet to price in the potential uptick in inflation, providing some upside potential for TIPS investors if inflation does return to trend at 2% or higher over the next year.
  • Increasing price pressure from the tightening employment market, the weaker U.S. dollar, and relatively stable oil prices are likely to contribute to rising inflation.
  • The Federal Reserve, which has made it clear recently that its focus on the tightening labor market and easy financial conditions will take precedence over inflation readings that fall short of its 2% annual target, stands as the most prominent obstacle to higher inflation and will likely serve as a cap on TIPS performance in the medium term.

Expectations for higher inflation following the U.S. presidential election faltered in the first half of 2017 as declines in oil prices helped drive the overall consumer price index (CPI) lower. However, we believe that the sub-2% annualized CPI readings we saw during the summer represented a low for the current inflation cycle. As a result of continuing solid growth in the broader economy and a tightening labor market, we expect inflation rates will stabilize or run moderately higher in the near term, followed by 2%—or higher—inflation in 2018.

As of late October, U.S. Treasury inflation protected securities (TIPS) have yet to price in the potential uptick in inflation. The 10-year breakeven rate, which represents the yield difference between 10-year nominal securities and TIPS and is a useful gauge of the market’s inflation expectations, traded around 1.88% in late October. This provides some upside potential for TIPS investors if inflation does return to trend at 2% or higher over the next year.

CORE CPI LOOKS READY TO MOVE HIGHER

The most recent print for annualized CPI was 2.2% as of September, when the effects of Hurricane Harvey led to a spike in gasoline prices and ended a run of four months when headline inflation came in under 2%. The oil refinery disruptions caused by the hurricane led to a 13% increase in gas prices and a 6.1% jump for the energy sector overall. The weather had less impact on core CPI, which excludes food and energy. It held steady at 1.7% for the fifth straight month, but we believe macroeconomic factors could contribute to a firming of core prices in the near term. We expect 2% core readings by the second quarter of 2018, which will also support higher headline CPI.

We have already begun to see a move toward higher prices in some core sectors. After some weakness in the second quarter, shelter prices increased 3.5% in the third quarter on an annualized basis, which is only slightly slower than the 2016 pace. Moreover, the core services components most affected by the business cycle (core services ex-shelter, ex-health care) have also been firming, with prices increasing at an annualized 2.8% rate over the third quarter.  

WAGES RISING AMID TIGHTER LABOR MARKET

Core services, which are more dependent on labor costs than other CPI sectors, will likely see increasing price pressure from the tightening employment market. Similar to the inflation numbers, the employment report for September was likely distorted by the recent hurricanes, but the tightening trend seems clear. The unemployment rate fell to 4.2%, the lowest level since early 2001. The unemployment rate was 4.9% a year earlier. Average hourly earnings rose 2.9% over the 12-month period ended in September.

Another factor that we believe will contribute to rising inflation is a weaker U.S. dollar, which will lead to higher prices of imported goods. Oil prices, meanwhile, have bounced back from the recent low of about U.S.$43 per barrel of West Texas Intermediate crude in June and have been trading in the U.S.$50 range—near where they started the year.  

LESS ACCOMMODATIVE FED LIKELY TO CHECK RISING INFLATION

The Federal Reserve stands as the most prominent obstacle to higher inflation and will likely serve as a cap on TIPS performance in the medium term. The Fed has made it clear recently that its focus on the tightening labor market and easy financial conditions will take precedence over inflation readings that fall short of its 2% annual target. Communications from Federal Open Market Committee (FOMC) members have recently been moderately hawkish, with Fed Chair Janet Yellen saying “it would be imprudent to keep monetary policy on hold until inflation is back to 2%” and that the Fed should be “wary of moving too gradually” due to concerns about overheating the labor market or creating financial instability.

The median rate projections that the FOMC released at its September meeting indicated that the central bank intends to hike rates in December, followed by three more increases in 2018. These moves could tamp down nascent inflation. The economic projections also showed that the Fed now expects to hit its 2% inflation (measured in terms of the personal consumption expenditure price index) target in 2019 rather than 2018 as it had previously forecast.

NEW CENTRAL BANK LEADERSHIP WILL PROBABLY HAVE SIMILAR APPROACH TO INFLATION

With Yellen’s four-year term as Fed chair ending in February 2018, there is some uncertainty about the future of monetary policy (although there is a possibility that President Trump will nominate her to a second term). In our view as of late October, the leading candidates to replace her seem likely to continue her approach to inflation or perhaps move in a slightly more hawkish direction.

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Important Information

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of November 2017 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance cannot guarantee future results. All investments are subject to market risk, including the possible loss of principal. Investing in bonds involves interest rate risk and credit risk. Deflationary conditions (when inflation is negative) could case a fund investing in TIPs to decrease in value. Yield and share price will vary with interest rate changes. Unlike the Treasury securities in which a TIPs fund invests, the fund is not insured or guaranteed by the U.S. government. All charts and tables are shown for illustrative purposes only.