Accounting for Inflation

The inflation conundrum dogging the US economy right now has a lot of observers scratching their heads.  The economy clocked 5% real GDP growth in Q3:2014 and an estimated 2.6% in Q4.  Unemployment at 5.6% is at levels that have historically begun to generate wage inflation, but there is little to speak of.  Explanations range from labor market slack to deflationary pressures from abroad, but economists at the Fed are pointing markets to a simpler answer:  zero interest rate policy.

According to Federal Reserve researchers[1], a basic accounting identity is likely at the root of the problem; the Fisher equation, which ties nominal interest rates to the real interest rate through inflation expectations, states that nominal interest rates must equal the real interest rate plus expected inflation.  The issue, as the Fed sees it, is that if monetary policy anchors nominal rates at zero but real GDP (a good indicator of the direction of real interest rates) is positive, then the inflation rate has to be negative.  In other words, the low rates set by the Fed could actually be contributing to low inflation, or as the Fed put it “the 2 percent inflation target is not consistent with zero interest rate policy and the longer the FOMC stays in the zero interest rate policy regime, the further the trend inflation will fall below the target.”  (This is not at all unlike the periodic bouts of deflation typical under a gold standard during periods of economic growth, where gold acts as the nominal price anchor).

Those wondering why the Fed seems to be marching toward rate hikes in mid-2015, despite global deflationary pressures and weak wage growth at home, may have their answer in this basic accounting identity for inflation.  The Fed has created a bit of a policy trap for itself and, contrary to conventional wisdom, it must raise nominal interest rates to achieve its 2% inflation target.

The portfolio implications of this are clear; heightened uncertainty about interest rates at both short- and long-term horizons argues for less reliance on bonds for capital preservation in portfolios.  Low Correlation Defensive strategies that benefit from interest rate volatility may be important growth drivers in this environment.  Finally, because the effect of this identity has also been to constrain economic growth, we would expect a move toward higher rates to stimulate growth rather than restrict it.  Under this paradigm, volatility hedging will be an essential component of portfolio construction