Inflation: back from the grave

Over the last few years, headline inflation, which includes food and energy prices, has been running well below normal. Eurozone headline consumer price index (CPI) inflation has been below 2% since 2013 and was at or below zero for most of 2015 and early 2016. U.S. headline CPI inflation was below 2% starting in June 2014 and was around 0% for most of 2015. Chinese producer prices declined from 2012 to late 2016. In fact, falling prices plus slowing growth meant that global nominal GDP actually shrank in 2015! The world was in deflation; inflation was deemed dead.

This coordinated fall in prices came about as commodity prices collapsed. But, over the last year, inflation came back to life as commodity prices stopped falling. By the end of 2016, inflation was clearly on firm footing. In China, year-over-year producer price inflation moved from negative to up 5.5% in five months. Eurozone producer prices stopped falling in December; CPI inflation moved above 1% for the first time since 2013. In fact, German consumer price inflation moved from 0.8% year-over-year in November to 1.7% year-over-year in December. Lastly, U.S. headline CPI finally moved above 2% for the first time since July 2014. While these inflation rates are by no means extreme, these are levels not seen in about four or five years.

Higher inflation is breathing air into nominal growth and profits. That is clearest in China. Nominal GDP growth has soared from a little over 6% to about 10% from the end of 2015 to the end of 2016. Industrial profits were up 14.5% year-over-year in November. Higher prices should take a bit of air out of the massive debt balloon to boot.

However, in the United States, there is question about whether higher prices will eat into consumer purchasing power. Over the past year, hourly wages grew faster than inflation; up 2.9% compared to a 2.1% gain in inflation. However, higher inflation is also eating into real wages. Real wages only grew 0.8% at the end of 2016, compared to 1.9% at the end of 2015. Going forward, we expect nominal wage growth to continue to be in the 3% range, that’s still likely ahead of any increase in the CPI. Gasoline prices are up a whopping 25% year-over-year! That seems scary, especially when you consider that a surge in gas prices is a telltale sign of recession. However, those recession fears are not well founded. That said, pump prices are still “cheap” at the national average of only $2.36 per gallon. So, gasoline prices are likely still a tailwind to consumers, albeit a much more modest one.

Through 2017, the resurgence in inflation that started last year should continue. Headline inflation should accelerate through February or March as the base effects from the fall in energy and commodity prices work through the data. By that time, headline CPI inflation in the United States could be upwards of 2.4%-2.6%, depending on analyst estimates. Inflation in Europe could gain more steam as well, moving to even 1.6% or 1.8%.

The move from deflation to reflation also has implications for central bankers. In the United States, the Federal Reserve (Fed) should continue their “gradual pace” of policy tightening. Tighter labor markets will likely provide further support to ex-food and energy, or core, inflation. In Europe, things will be more complicated. Headline inflation is already near 2% in Germany, but core inflation remains broadly weak, at 0.9% year-over-year for the Eurozone as a whole. By year-end, there is a risk that the European Central Bank (ECB) could feel pressure to prematurely wind down asset purchases.

With the collapse in commodity prices, inflation was left for dead. But, it has clearly come back to life. That’s good news for nominal growth and company profits, and it is not going to be terrible for consumers. Central bankers will be happy too. The scourge of deflation looks close to defeat. However, policy makers should be cautious not to get ahead of themselves; or, inflation could fall back into the ground as quickly as it was revived!

 

Follow Principal Global Investors on LinkedIn

 

_________________________________________________________

Unless otherwise noted, the information in this document has been derived from sources believed to be accurate as of January 2017. Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity. Past performance is not necessarily indicative or a guarantee of future performance and should not be relied upon to make an investment decision.

The information in this document contains general information only on investment matters. It does not take account of any investor’s investment objectives, particular needs or financial situation and should not be construed as specific investment advice, an opinion or recommendation or be relied on in any way as a guarantee, promise, forecast or prediction of future events regarding a particular investment or the markets in general. All expressions of opinion and predictions in this document are subject to change without notice.  Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security, nor an indication that Principal Global Investors or its affiliates has recommended a specific security for any client account

Principal Financial Group, Inc.,  Its affiliates, and its officers, directors, employees, agents,  disclaim any express or implied warranty of reliability or accuracy (including by reason of negligence) arising out of any for error or omission in this document or in the information or data provided in this document.  

Third party content, such as comments to this blog, is not reviewed by Principal Global Investors before it is displayed, although we may remove, alter, edit or adapt any such comments.  Principal Global Investors does not endorse, authorize, or sponsor any third party content.  Links contained in some blog posts may take you to third-party sites and Principal Global Investors makes no guarantees to the accuracy of the information provided.

©2016 Principal Financial Services, Inc.

Principal, Principal and the symbol design and Principal Financial Group are trademarks and service marks of Principal Financial Services, Inc., a member of the Principal Financial Group.  Principal Global Investors is the asset management arm of the Principal Financial Group.

Principal Funds are distributed by Principal Funds Distributor, Inc.

t1701230apb