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Investment Outlook - Second Quarter 2018

Boom or Bust - Inflation Watch Update 

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By: Dennis Fulmer
Monday, July 16, 2018

DennyOne recent anecdotal story from the Dallas Morning News reports that some workers in the oil-rich Permian Basin have gotten 100% pay raises.  The labor market is very tight nationwide, and recent economic data indicates a 4% growth rate for the second quarter.  Are we beginning a boom period which results in accelerating inflation and higher interest rates?  No one can answer this with certainty because of the unprecedented actions that all of the central banks have taken over the last several years.  Just like our Fed, they have purchased lots of bonds in the open market to keep interest rates low.  However, our Fed has begun to shrink their holdings of bonds along with implementing several hikes in interest rates.  Both of these measures are steps in reversing the easy money that borrowers have enjoyed for the last nine years.  As we discussed in our last issue, the economy follows money growth, and the Fed is now pushing back against the strong economy.  Some pundits argue that the Fed policy is still very easy and only moving towards a neutral position, not a tight position.  James Grant, the author of Grant’s Interest Rate Observer, states that “since 1962, the inflation-adjusted rate on the 10-year Treasury note has averaged 2.3%.”   With the most recent 2.8% CPI number for the last twelve months, a neutral rate on the 10-year should be 5.1%, a far cry from the current 2.91% yield that we see today.
 
What tempers this dire outlook is that the tightening moves by the Fed have shown results.  Many commodity prices, like copper, lumber, and gold have retreated in recent weeks.  The U.S. dollar has been climbing for several months, another sign that the money supply is held in check.  Also on the positive side, the Saudi’s have decided that oil prices have risen too much, so they increased their production which has slowed the rise in crude prices.  This is noteworthy because energy prices have been the biggest driver of the rising inflation by increasing 11.7% over the last twelve months. Thirty-year mortgages have risen to about 5% which may account for the recent slowdown in the increase in home prices.     
In summary, it looks like the Fed is on the proper course as their moves have started to show results.  Inflation is not likely to spiral out of control. Therefore, interest rates are unlikely to shock us to the upside.
 

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