Inflation – the change in general price levels – in the United States is below average due to factors that include depressed global commodity prices due to excess supply and weak demand, and slowly rising wages resulting from the 2008 financial crisis and slow economic recovery. The headline Consumer Price Index (CPI) is up only 0.1% year-over-year in June, which is well below the historical average of about 2.1%. The core CPI, which strips out food and energy prices, is up 1.8% from a year ago; this is close to the Federal Reserve’s target of 2%. Globally, inflationary trends are weak as most major economies (such as China, Japan, and Europe) are weak or slowing. Generally, investors should not currently be concerned with rapid inflation, but they may be affected by the global disinflationary trends.

What Is Inflation?

Inflation is a rise in the level of prices for goods and services. There are multiple measures of inflation in the U.S., with the CPI being the most commonly cited. The CPI tracks the prices of a representative basket of consumer goods and services for urban consumers. The so-called headline CPI reports the change in prices of all goods and services in the basket. The core CPI removes energy and food prices, which tend to be more volatile and subject to pressures outside of the normal business cycle. Most economists believe core inflation is a better representation of the fundamental price pressures faced by consumers.

In the U.S., the 10-year historical average rate of inflation is about 2.1%, down from about 2.8% before the 2008 financial crisis. This compares to average inflation rates of about 2% in the European Union, 0.3% in Japan and 2.9% in China.

Fed Inflation Target

The Federal Reserve targets a different measure of inflation measured by the price deflator for personal consumption expenditures (PCE). The PCE Deflator differs from the CPI in that the CPI tracks a similar basket of goods and services over time, whereas the PCE Deflator measures the prices of goods and services actually purchased during a certain point in time.

One of the Fed’s policy goals is to achieve stable prices, generally defined as approximately 2% inflation measured by the Core PCE Deflator (i.e., PCE deflator less energy and food prices).

Inflation Outlook

The outlook for U.S. inflation is subdued, with below-average inflation for the next five to 10 years. There are several ways to interpret market expectations for future inflation. For example, the Federal Reserve publishes break-even inflation rates, which indicate the bond market’s implicit expectations for inflation over various periods of time. The latest breakevens indicate expectations for average inflation of 1.5% over the next five years and average inflation of 1.8% over the next 10 years. This also implies an average rate of inflation of 2.1% over the five years starting in 2010.

Should Investors Worry About Inflation?

Most indicators suggest that investors should not worry about the type of runaway inflation that the U.S. experienced in the 1970s and 1980s. Over the past 30 years, the Federal Reserve has shown that it is capable of curbing inflationary pressures. Moreover, economic conditions remain soft and are not showing signs of building inflationary pressures. In particular, commodity prices are actually in a deflationary trend, wage growth is slow, capacity utilization is below 80 to 82% (which is typically a threshold for rising prices), and a new credit cycle has not gained traction yet. On the contrary, there is a worrisome global trend of disinflation, a slowing rate of inflation. This could affect investors in particular markets, including bonds, commodities and currencies.

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