Even if inflation were to heat up more and temporarily surpass the 2% range, it shouldn't cause the damage that some are predicting, including sending stocks lower. According to Vanguard's global chief economist Joseph Davis, hawks fear that, if inflation overshoots 2% on a temporary basis, it could result in a decline in the dollar's purchasing power and prompt the Federal Reserve to engage in rate hikes over the longer term, sending stocks lower. However, Davis isn't in that camp.
In a research report, the Vanguard economist said there is no cause for alarm. "A cyclical uptick in inflation, even if it temporarily overshoots 2%, wouldn't cause the damage," wrote Davis. "Longer term, we expect the economy's growth and inflation prospects to remain subdued relative to historical standards. Our research shows that long-term forces, including a shrinking labor force, technological disruption, and expanding globalization will continue to weigh on prices for years to come." The economist did note that inflation is moving higher based on a number of measures, including the Personal Consumption Expenditures Price Index, a favorite of the Federal Reserve, which is nearing the 2% target level. Still, Davis stressed that moving higher isn't the same thing as being high.
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Vanguard is sticking with its outlook that the Federal Reserve will raise interest rates three times this year and three in 2019, which would take the Fed funds rate near 3% before it stops raising rates. Davis said that the Fed could even start cutting rates again in 2020. "Our forecast anticipates a six-month 'pause' in Fed tightening when the fed funds rate rises above 2% and above the likely rate of core inflation after September," wrote Davis. "Whatever the change, it won't alter our longer-term market outlook. The good news is that as short-term interest rates edge up, so will our expectations for longer-term stock and bond returns, as the risk-free rate is the foundation for both."
In December, when stocks were setting new highs seemingly every month, Vanguard warned that 2018 will be marked by higher risks and lower returns, pressuring investments for equity and bond investors, largely those in the U.S. Vanguard's outlook for global stocks and bonds was described by the money manager as the most "subdued" it has been in a decade, with Vanguard forecasting at the time that U.S. equity returns would be in the 3% to 5% range, which is much lower than the 10% annualized return generated over the past 30 years. According to Vanguard, stocks and bonds outside the U.S. could see returns that are around 5.5% and 7.5%, highlighting the benefit of globally diversified portfolios in the years to come. The expected return on fixed income is muted at between 2% and 3% for the next decade, but at least it remains in positive territory.