Is U.S. Inflation Too Low?

inflation 600X300Rick Rieder looks beyond the headline inflation level to gauge whether the U.S. has an inflation problem.?

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One reason the Federal Reserve (Fed) has delayed initiating its first rate hike in years: Headline U.S. inflation has been persistently running below the stated 2 percent level the central bank seeks to target.

While the Fed certainly considers much more than the superficial headline number in its analysis of inflation, some of those who interpret the Fed’s actions make this overly simplistic assertion: Inflation is too low today and therefore justifies the maintenance of low policy rates.

I disagree. In my opinion, the discussion of inflation as a simple headline number is too one-dimensional. To understand why, it’s helpful to take a deeper look at the makeup of U.S. inflation.

The Impact of U.S. Inflation

In reality, according to my team’s analysis of data accessible via Bloomberg, inflation is experienced in vastly different ways across income groups, industries and geographies.

In the U.S., for example, those in the bottom quintiles of income distribution spend a much larger percentage of their expenses on food-, energy-, and rent-related expenditures than higher earners. As such, a significant increase in the energy, rent or food expenditure categories would likely adversely impact lower income households much more than it would those in the upper income quintiles. Likewise, the disinflationary tailwind of lower oil and gas prices should provide a much greater disposable income boost to lower income households than higher income groups, as the former generally spend a larger share of income on energy.

Even more importantly, inflation can be disaggregated into “good” and “bad” inflation.

According to my team’s analysis of data via Bloomberg, “good” inflation can be viewed as price increases resulting from accelerating economic activity and a strong labor market, and thus, most likely to further support rising wages and employment. This sort of inflation most often shows up in expenditure categories such as vehicles, recreation, transportation, medical care, home furnishings and housing. In other words, price rises in these categories are likely a result of an improving economy.

In contrast, “bad” inflation can be viewed as rising prices resulting from supply shocks that aren’t necessarily indicative of economic strength in the U.S. This sort of inflation tends to show up in expenditure categories such as food, energy, motor fuel and apparel. Prices for these expenditures can, and do, rise with less of a tie to expected growth in the economy, and therefore such price rises tend to detract from incomes more than they’re likely to support them. Also included is rent, which tracks the health of the overall economy similar to “good” categories, but decreases disposable income without a coincident rise in asset wealth.

So what does this mean for today’s level of inflation? According to my team’s analysis, we’re currently seeing more “good” than “bad” inflation, as the figure below shows. In other words, inflation is in a healthy economic state of being vs. being an economic risk or headwind.



This balance, however, could shift quickly in a world of excessively easy money. As such, I was pleased to read the Fed’s most recent policy statement, which leaves the door open for an initial rate hike in December. After the October employment report, I believe the Fed is in a position to initially hike rates next month. The conditions that the Fed has said it was waiting to see before liftoff are actually in place; they’re just not being reflected in the headline inflation data because of the transitory nature of lower energy prices. In other words, headline measures are being distorted lower by declining energy and food prices, declines that aren’t reflective of any economic shortfall. In the end, inflation is a complex topic, but too many discussions of policy appear to miss this complexity and miss the fact that it’s primarily lower income households that are hurt by rising prices. The bottom line: The treatment of “inflation” as a simple headline number that needs to be pushed higher paints too simple a picture.

Rick Rieder, Managing Director, is BlackRock’s Chief Investment Officer of Fundamental Fixed Income, Co-head of Americas Fixed Income, and is a regular contributor to The Blog.

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