Inflation in the U.S. has picked up in recent months, toward the top end of Federal Reserve forecasts.
While several Fed officials remain focused on building inflationary pressures, Fed Chair Janet Yellen has recently struck a dovish tone, stressing her concerns about global growth and financial conditions as reasons to proceed cautiously with interest-rate hikes.
Some investors, balancing the doves' and hawks' views, are concerned the Fed may prioritize "full employment" over price stability, and that, by waiting too long to act, the Fed will be forced into a rapid series of growth-killing hikes. The minutes from the March Federal Open Markets Committee meeting indicated some uncertainty, with a mix of participants' views as to whether the pickup in U.S. prices was "consistent with a firming trend" or was "unlikely to be sustained."
Looking at the data and the Fed's deliberations, should investors be worried that the Fed is losing sight of inflation?
A number of recent data points have helped convince markets that inflation is indeed heading higher. The core personal consumption expenditure index (PCE) rose 1.7 percent year-over-year in both January and February, accelerating from 1.3 percent just five months before. The increase in prices was broad-based.
Most tellingly, service-sector inflation, as measured by the consumer-price index for services excluding energy, rose 3.1 percent in the year to February. That's important because it closely reflects domestic wage pressures. It finally seems that the low jobless rate, which was at 5 percent in March, is starting to feed through into accelerating inflation.
Trends in foreign exchange and commodity markets have recently been pushing in the same direction. The dollar fell 3.8 percent in March on a trade-weighted basis, its largest monthly decline since September 2010. This has the potential to add to the inflationary momentum by lifting import prices. And the price of oil has now rebounded around 40 percent from February lows, back towards levels seen in December last year.
Yet Yellen has stressed risks to global growth and said she anticipates "only gradual" rate rises over the coming years. This tallies with the view of several Fed members in March "… that a cautious approach to raising rates would be prudent … [noting] their concern that raising the target range as soon as April would signal a sense of urgency they did not think appropriate."
It is too soon for equity investors to worry that the Fed will need to rush rate increases in order to dampen inflationary pressures. Yellen has made a point of signaling that the Fed will be willing to let inflation run closer to or above target for longer before reacting, judging that the risks of inflation getting out of hand at some point in the future are not as large as the risk of acting too soon and choking economic recovery.
U.S. growth remains moderate. Global overcapacity, a strong trade-weighted dollar, and still tepid external demand should act as a counterbalance to U.S. inflation, even if wage gains surprise more positively.
We should remember that the Fed doesn't set policy in a vacuum. If inflation rates outside the U.S. fail to respond to stimulus and prompt further monetary easing abroad, even slow Fed hikes could lead to the dollar strength that is its own form of tighter monetary policy.
The bottom line is that it does not seem as though the Fed is losing sight of inflation, or running behind the curve. Recent economic data and still modest global growth conditions justify only gradual U.S. rate rises through 2016. Still-accommodative Fed policy and an expected pickup in equity earnings support our overweight U.S. equity position in global portfolios, and we still expect equities and credit to end the year higher.
Commentary by Mark Haefele, global chief investment officer at UBS Wealth Management, overseeing the investment strategy for $2 trillion in invested assets. Follow him on LinkedIn at www.linkedin.com/in/markhaefele.
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