Inflation: Why It May Surprise To The Upside


An improving domestic economy has resulted in a tight labor market and an undersupplied real estate market, which we expect could translate into more stable goods prices and a continued increase in wages and housing costs. We believe current market-based measures of inflation expectations may underestimate the likely impact of these pressures on future inflation data.

Construction costs rising along with real estate prices

Low spare capacity and few signs of excess supply underpin our belief that higher real estate prices may be on the way. Research suggests that supply growth of multifamily housing units is abating because of increasing construction and financing costs. Meanwhile, job growth has fueled demand for housing, pushing vacancy rates lower. The ensuing imbalance has inflated rental prices. Due to the recent increase in mortgage rates and higher home prices, we expect some cooling in housing transactions in the near term as potential home buyers wait for more supply and hope for lower mortgage rates. However, we believe these buyers eventually will feel compelled to buy at slightly higher costs, which could result in continued upward pressure on overall shelter cost inflation.

Current owner’s equivalent rent (OER)—which comprises about 1/3 of the overall consumer price index—is running at a 3.25% annual rate. We think OER could rise to 3.5% to 4.0% over the next year, which could push core inflation up by another 0.3% or so, putting it ahead of consensus estimates. Rising interest rates have not historically shown much empirical impact on real estate inflation; rather they impact housing activity, and we therefore do not include them in our internal inflation models. However, we note that the national average mortgage rate has risen by about 0.6% year-to-date, which has dampened housing affordability and should eventually flow through to higher OER. We expect longer-term housing formation to remain strong due to favorable demographics and employment backdrop, but dwellers may shift from owning to renting as home prices are rising faster than wages, decreasing affordability (Figure 1).

Figure 1: Weaker housing affordability should push up OER

As of 30 June 2018 | Sources: Bureau of Labor Statistics, National Association of Realtors

Lumber and panel prices have risen markedly over the last two years, and labor is again tight in construction trades, despite adding supply at a level below demand creation. Part of the increase in construction costs can be explained by a shortage of labor arising from an older construction workforce. Rising construction costs may be a negative consideration for builders, but the rising replacement cost of a home is a positive one for existing home prices.

Tight labor market putting upward pressure on core services prices

It is increasingly evident to us that the US economy’s capacity is under strain due to large fiscal and deregulatory stimuli. Improvement in real consumption has been aided by rising consumer confidence and strong regional manufacturing sentiment. Looking ahead, we expect continued increases in wage growth and core inflation as capacity conditions tighten and bottlenecks remain acute. Above-trend growth amid fiscal stimulus and deregulation also remain important tailwinds which, taken together, should put upward pressure on core services prices.

Recent inflation data has shown continued strength in domestically generated core services prices, driven in part by higher shelter costs. Cost and quality of labor remain two of the most significant issues facing small businesses, according to a recent National Federation of Independent Business survey. As the labor market tightens, more employees are choosing to leave their current jobs expecting to find better ones. Along with strong wage intentions from business surveys, this leading indicator points to a potential lift in wage growth and core inflation over the next 12 months (Figure 2).

Figure 2: Tight labor market could lift wages/prices further

Chart data is from 31 January 1986 – 30 June 2018 (LHS) and 30 September 1987 – 31 March 2018 (RHS) and has been seasonally adjusted. Sources: Bureau of Labor Statistics, Haver Analytics

Medical Inflation — the largest sub-component of core services — has been depressed over the last decade due to the introduction of regulations that reduced Medicare payments. This had a knock-on effect on the cost of private medical services, as private insurers were in a better position to negotiate price reductions from health-care providers.

However, this is likely to move in the reverse direction going forward: Medicare reimbursement rates have jumped in 2018 and are scheduled to increase further in 2019. In addition, Medicare payments to doctors are expected to surge in 2019 due to incentive payments under the Medical Access and Children’s Healthcare Insurance Program Reauthorization Act. In addition, the repeal of the individual mandate is likely to result in higher costs for uncompensated care; this combined with projected higher wage growth, is likely to lead hospitals to negotiate higher rates of payment from private payers.

Less deflation from core goods

Unlike core services prices, core goods prices have acted as a persistent deflationary force for the last several decades. While we have not yet witnessed a pick-up in goods inflation, we expect these deflationary pressures to abate — our current leading indicators suggest core goods inflation could rise to near 0% from about -0.5% over the last few years. Over the past two decades, a decline in global trade barriers resulted in cheaper imported goods from areas of the world with lower production costs. As we look forward, we see a world where higher emerging market wages, coupled with higher transportation costs, could result in less offshoring opportunities and a weaker deflation impulse on core goods. Add to this an increase in protectionist trade policies in the US, and we could experience upside surprise in core goods inflation.

A potential source of higher goods inflation also could stem from increased domestic transportation costs. Freight indicators show very strong shipments set against tight supply, which is expected to lead to a surge in freight prices, which should continue given the lengthening in supplier delivery times. Our equity retail specialists — with whom we collaborate to form our inflation view — have cited a shortage of truck drivers, contributing to higher transport and input costs. In the near term, we expect this cost to be absorbed in business operating margins, but if it persists it eventually would show up in higher consumer prices.

Risks to our outlook

Our proprietary models forecast the year-over-year core consumer price index to rise to around 2.5% by the fourth quarter of 2018. The downside risk for the inflation outlook largely stems from productivity developments. If productivity accelerates faster (relative to wage growth), it would be an important factor in keeping unit labor costs low and maintaining business margins. While not our core case, we believe this scenario bears close watching, given our medium-term productivity analysis, and would help support profit margins and risk assets. We also are vigilant in watching for signs that competitors across select industries may selectively attempt to take market share through price reductions, as occurred last year with mobile telephone plans.

By Wellington Management
Jeremy Forster, Fixed Income Portfolio Manager
Jeremy Forster is a fixed income portfolio manager on the Broad Markets Team. He focuses on global macro and US rates strategies, including developing fundamental and market-driven valuation models and determining relative value across sectors.
Allan Levin, CFA, FRM, FSA, Fixed Income Portfolio Manager
Allan Levin is a fixed income portfolio manager on the Broad Markets Team who focuses primarily on inflation-linked and interest-rate markets. In this role, he develops macro, relative value, and systematic investment strategies that he implements in both sector-specific and multisector portfolios.

For informational purposes only. Views expressed are those of the authors, based on available information and subject to change, and should not be taken as a recommendation or advice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. Any forward-looking estimates or statements are subject to change and actual results may vary.
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