The average annual rate of inflation in the United States has been slowly (if unevenly) declining for the past 40 years. Inflation rates averaged about 4% per year in the 1980’s, declined to around 3% in the early1990’s, fell below 1% by 2010 and today hover just under 2%. If we study market-based indicators of future inflation, we see that these have declined dramatically as well. In fact, current yields on US Treasury Inflation-Protected Securities (“TIPS”) imply that inflation will average only 1.6% for the next five years, and only 1.75% for the next ten years. Ironically, this current period of muted inflation coincides with the largest monetary expansion (“Quantitative Easing”) ever conducted by the Federal Reserve, in which large amounts of new money was created to purchase US government securities, thus reducing long-term interest rates. It should be clear by now that so-called ‘money-printing’ by the Federal Reserve did not lead to excessive increases in general price levels.

 

 

If one looks hard enough, there are pockets of inflation that still exist – healthcare costs, college tuition & textbooks, child care services, and coastal real estate primarily. But to a large extent, the prices on many categories of consumer expenditures are stable or outright declining. This is certainly good news for most consumers, and helps our hard-earned dollars go further.

Of the many factors contributing to the decline in inflation, three are most commonly cited:

  • Demographics – the world population, on average, is aging. Older people consume less than younger people, in particular those “first-time” large purchases such as homes, automobiles and appliances. (This is not the case for health care services, which has yet to see costs stabilize.)
  • Debt – the world in general is more indebted than it ever has been. Large amounts of government and corporate debt, and their associated servicing costs, probably reduce economic growth rates and act as an anchor, weighing down aggregate demand. Reduced growth rates lower many prices, particularly for economically sensitive areas like energy and commodities.
  • Technology – mobile devices combined with high speed internet communication have significantly reduced frictions and profit margins in many industries. For example, consider what Uber and Lyft have done to the price of taxi (ride) services, or what video streaming services have done to expensive cable TV subscriptions.

Importantly, all of these factors are long-term, structural, and are not expected to change for the foreseeable future.

Despite the benign inflation statistics, the key overnight interest rate set by the Federal Reserve is still around 2.4% today, well above the present rate of inflation. A major consequence of this is that ‘real’ (after inflation) yields are now quite high in the United States when compared to most other countries. The five year real yield on US TIPS is about 0.45%, which means you can earn a real return of almost ½% with no credit or inflation risk. This high rate of real return has created strong demand for the US dollar, and the trade-weighted USD index now sits very near 50 year highs.

 

 

There are trade-offs to a strong local currency, and your preference may vary depending on whether you see yourself primarily as an investor or as a consumer. First, there is no doubt that the strong dollar has been a drag on the returns of foreign bonds and equities for many American investors. While owning a highly diversified portfolio is an intelligent strategy for risk reduction in the long run, returns have nonetheless suffered lately relative to portfolios that are more heavily skewed toward US investments. Second, US based companies that rely heavily on the export market will find this kind of environment challenging, which can lead to more off-shoring of jobs and production to reduce costs. On the upside, foreign imported goods are much cheaper for US consumers thanks to a high dollar value. And finally, just as it was in the early 2000’s, this might be a great time to consider that foreign vacation you’ve been dreaming about!

Sources:      https://fred.stlouisfed.org