Inflation and Bonds: An Update

October 4, 2018

We have been blessed with an extended economic expansion in the U.S. that has come with relatively little inflation.  Since the financial crisis of 2008, inflation in the U.S. has been very low, averaging well below 2%.  Indeed, the Federal Reserve’s stated inflation target of 2% per year has rarely been met over the past decade. Our country’s low inflation rate has been good for American consumers and for American business.  When prices rise modestly relative to income growth, Americans can afford more things—and a higher standard of living.  Economic growth combined with low inflation is a great combination for elevating families out of poverty and into the middle class. But there continues to be concern about overheating.  Unexpected inflation occurs when a society has too many dollars chasing too few goods.  By way of example, we are at an 18-year low unemployment rate in the U.S. today.  The national unemployment rate is below 4%.  It is a great time to be a job seeker.  Firms across the U.S. must raise wages and compensation in order to attract new workers.  And over time, this rise in wages is inflationary for the economy.  Another major factor in calculating inflation is owner equivalent rent: in other words, the cost of housing.  Since the 2008 recession, housing prices and rent prices have rebounded massively across nearly the entire country. But inflation remains modest as of today’s writing.  The most recent monthly reading of the personal consumption expenditures (PCE) price index was flat in August.  Annualized, the core PCE is running at 2% year over year.  This is the measurement that the Fed uses to assess inflation in the U.S. We remain sensitive to inflation, and other pressures that might influence interest rates to move higher.  Accordingly, we favor bond funds with our clients that are partially hedged against interest rates rising.  These funds seek to outperform the benchmark, the Barclay’s Aggregate U.S. Bond Index.  The index is down 1.31% in the trailing twelve months, mostly due to rising interest rates over this period. In the near term, we actually welcome rising interest rates because they are mostly attributable to economic growth (and not merely inflation).  Should inflation begin to emerge above 2% in the coming years, we will re-evaluate investment portfolios to make sure that they are properly defending against a loss in real buying power.  Stay tuned.   The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. An increase in interest rates may cause the price of bonds and bond mutual funds to decline. Investing in mutual funds involves risk, including possible loss of principal. No strategy assures success or protects against loss.