• Wealth Management

Higher Inflation Could Be Coming

Even though inflation has remained muted so far this year, recent policies out of Washington could cause it to climb.

While many investors aren’t worried about inflation right now, I’m growing more concerned. To be sure, most measures of inflation are tame and interest rates are still at historically low levels (inflation can spark a rapid rise in long-term rates, which is one reason it can be negative for markets and the economy).

But make no mistake: Prices are already rising – the fastest in a decade on a three-month rolling basis.

We are late in the economic cycle, when prices typically accelerate. However, policies emerging from Washington aren’t helping matters.

The Trump administration was already contributing to nascent inflation pressures (for example, with the apparent fondness for a weak dollar, which can lead to higher import prices), but the past couple of weeks have brought more reasons for concern.

Here are three trends out of Washington that could lead to rising inflation:

Trade Protectionism: This includes everything from new tariffs, to threats to charge China with intellectual property violations, to potentially exiting NAFTA. Tariffs and trade wars are unambiguously inflationary. 

Anti-globalization and nationalism: Here I’d note there have been a few blocked cross-border mergers. I also think there is a possibility there could be new sanctions on Iran, which could impact oil prices.

Stated weak dollar policy: A weaker greenback raises the cost of imports. Already, the 10% year-over-year change in the trade weighted dollar is creating headwinds for consumers. The most recent reading on import costs is that they are rising nearly 50% faster than overall CPI at a 3.5% annual rate.

I’ll also mention that while deficit-financed tax cuts are stimulating the economy, they are paid for by increasing Treasury issuance – now up 30% year-over-year. That not insignificant bump could prove enough to alter supply-demand dynamics, contributing to higher rates.

The bond market may be too complacent about the impact of these policies. Economic reports on wages and consumer prices have been reassuring lately, but they tend to be lagging indicators.

Bottom Line: While a little inflation is healthy for an economy recovering from financial crisis, I’m concerned it could snowball from here. A sharp rise in inflation would require the Federal Reserve to accelerate its rate hike plans, which could cause bond prices to fall and lead to a spike in broader market volatility. Worst case: The Federal Reserve overdoes it on rate hikes, which could usher in a recession. That’s certainly not imminent, but I’m watching inflation expectations for signs that inflation, Treasury yields, and market volatility could head higher.   

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MORGAN STANLEY ACCESS INVESTING