Inflation Comes Skulking Back

Red eye frog on the forest; Shutterstock ID 171235517

Like the proverbial frog that does not notice the rise in water temperature until it’s too late, investors seem to be experiencing a similarly stealthy rise in inflation. Changes in headline inflation measures suggest a gentle firming in prices. However, underneath the surface there is evidence that inflation may continue to rise past the steady 2% nirvana that central banks prefer. Consider the following:

Housing costs are now rising at the fastest pace in nearly a decade.

Housing is a major component of core inflation, i.e. inflation without volatile food and energy prices. The main housing component in the Consumer Price Index (CPI) is Owners’ Equivalents Rent (OER). As overall housing costs make up over 40% of core inflation, this is a key metric to watch. Last December OER rose over 3.5% from the previous year, the quickest pace in nearly 10 years (see the accompanying chart).

Owners' Equivalent Rent

Medical inflation is not as contained as many had hoped.

A few years back it seemed that medical costs were finally under control. That conclusion now appears premature. CPI for medical care has been rising at roughly 4% year-over-year for the past six months. With the exception of a brief period in 2012, medical costs have not been rising at this rate since early 2008.

Wages are rising.

One of the defining aspects of this recovery has been persistently sluggish wage growth, even in the face of a strong labor market. That is slowly changing. While still muted by historical standards, average hourly earnings are rising by 2.9% year-over-year, the fastest pace since the spring of 2009. A potential bolster to the trend: 20 states raised their minimum wage rates as of the first of the year.

Consumer inflation expectations are also starting to tick higher.

Up until recently consumer expectations for inflation remained muted. This was arguably a function of plunging oil and gasoline prices, which seem to exert an oversized importance in consumer perceptions of inflation. With oil and gasoline more stable, expectations are changing. The University of Michigan’s one-year inflation expectation survey is now at 2.6%, up 0.4% from the previous month.

None of this signals ’70s style inflation; it does suggest inflation may surpass still modest market based expectations. While 10-year inflation expectations, measured by the Treasury Inflation Protected Securities (TIPS) market, recently rose to 2.05%, they remain well below the 2.6% level reached in early 2013, a time when core inflation was roughly 50 basis points lower than it is today.

To the extent realized inflation and inflation expectations continue to rise, investors may want to consider several themes in their portfolios: a preference for TIPS over nominal Treasuries, an overweight to financial stocks, typically beneficiaries of higher interest rates, and an underweight to bond market proxies, such as utilities and consumer staples. Finally, should inflation expectations rise faster than nominal rates, gold is likely to continue to merit a place in most portfolios.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal. Past performance is no guarantee of future results.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of January 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Why Reflation Has Room to Run

Technicians with multicolored network cables.; Shutterstock ID 463797389

The recent jump in global bond yields represents a reflationary reawakening just a year after deflation and recession fears were dominant. Is this another false dawn? We don’t think so. This is an important psychological shift for investors previously obsessing over downside risks to growth and inflation, typified then by the talk of “secular stagnation” and “liquidity traps.”

The latest trend started in July when bond yields bottomed at record lows. Signs of a global growth pickup stoked the more confident mood, as did Donald Trump’s surprise U.S. presidential victory. We believe this reflationary phase, which central banks have been trying to achieve with years of ultra-easy monetary policy, has further to run.

Wage growth, long missing in the post-crisis expansion, is a crucial part of the reflationary dynamic, as we write in our new Global Macro Outlook Waking up to reflation. U.S. wage gains are feeding higher inflation and solid consumer spending, supporting profits in the face of rising labor costs. We believe companies have scope to tolerate even higher wage inflation in a stronger growth environment, either by hiking product prices or through a modest decrease in profit margins. Our analysis shows that profits can improve even with rising wages—indeed, this is a hallmark of reflationary economic phases.

Labor vs Capital

Wages and profits can, and typically do, rise together during the reflationary phase of economic expansions. In the U.S., this was the case in the late 1980s, late 1990s and the mid-2000s. The key ingredient? Solid and rising aggregate demand.

The lack of stronger wage growth was a root cause behind fears of the U.S. economy’s fragility and the downside risks to inflation. Thus, it would be misleading to think that rising wages have a direct link with subsequent economic downturns. Economic cycles do not die of old age, as the Federal Reserve has repeatedly noted. In this case, we see no reason to believe that the seeds of reflation will sow the expansion’s demise just now. Most recessions can be explained by a sudden hit to aggregate demand, either due to some external, financial or policy-related shock.

This U.S. profit-wages dynamic has the potential to broaden and go more global. Any uptick in U.S. capital investment or productivity kick would give companies even more flexibility to lift wages. Elsewhere, this virtuous cycle is starting to take shape. In Europe, the slack created by the 2007-08 and 2011-12 crises is slowly being taken out. Labor market reforms have expanded the workforce in Japan, helping explain why wage growth remains limited even with the country’s unemployment rate at three-decade lows. A better synchronized global recovery would make this bout of reflation more powerful.

Global structural challenges do remain, particularly the record debt levels across the world. Combined with low growth and aging population, this is likely to hold down long-term bond yields in Europe and Japan. With financial markets much more tightly integrated globally, these external forces should limit how high U.S. yields can rise. And even in the U.S., where household debt levels have been reduced, leverage remains higher than at the start of previous tightening cycle. This implies any given increase in policy interest rates is likely to have a bigger economic impact than was the case pre-crisis.

There are risks to our outlook. U.S. President Donald Trump has raised hopes for looser fiscal stimulus, but the makeup of any changes is key. His approach to trade and foreign policy could present risks. Unexpectedly rapid U.S. dollar appreciation could cause emerging-market instability with global spillovers.

But we believe a moderate rise in the dollar is more likely, and the support for profit margins from better wages, spending and nominal growth reinforces our broadly positive view on risk assets and equities in particular. This has been far from a typical recovery: Healing the post-crisis economic wounds has meant U.S. businesses and consumers took longer to regain confidence and animal spirits. These now seem to be revving up.

The revival of animal spirits may start to drive more investors out the risk spectrum, reinforcing our expectation that there’s potential for a risk appetite recovery. Finally, modestly higher bond yields support our view that the rotation into value and momentum shares away from low-volatility equities likely isn’t over. Read more market insights in my full Global Macro Outlook.

Jean Boivin, PhD, is head of economic and markets research at the BlackRock Investment Institute. He is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of January 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is the registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Inflation Is Not Dead Yet

rubber-bands

After declaring inflation all but gone last summer, investors are now deciding that calling the time-of-death might have been a bit premature. Starting in September and accelerating post-election, 10-year inflation expectations, measured by 10-year Treasury Inflation Protected Securities (TIPS), are surging. Breakeven levels (the difference between a yield of a nominal bond and an inflation-linked bond) are up over 40 basis points (bps, or 0.40%) from the summer low and over 80 bps from the February nadir.

Last October, I suggested that inflation expectations were too low. Despite the recent rally, here are four reasons why I think the rebound in inflation and inflation expectations is likely to continue into 2017.

1. The recent rebound simply represents a reversion to the mean.

While breakevens have moved dramatically, they’ve only reverted to the post-crisis average; 10-year breakevens remain 20-30 bps below where they were in the early summer of 2014. Investors are still not expecting any real pickup in inflation beyond the post-crisis norm.

2. Core inflationary pressures continue to build.

Two of the key components of core inflation, medical costs and housing, are accelerating. Consumer Price Index (CPI) Medical Care is now running at 4.25%, roughly double the level from two years ago. The rise in medical costs appears to be a function of a structural change in deductibles and out-of-pocket expenses. Housing costs also continue to rise. Owners Equivalent Rent (OER) is now running at roughly 3.4% year-over-year, the highest since spring of 2007.

3. Prices on cyclical commodities are spiking.

While oil prices have grabbed the headlines, industrial metal prices are also surging. The magnitude of the increase is almost certainly exaggerated by speculation and a growing preference in China for dollar denominated assets. That said, the change was already underway pre-election. The JOC Industrial Commodity Price Index is up 40% year-over-year. See the chart below for individual metal prices. Historically, there has been a tight correlation between industrial metals and 10-year breakevens, a relationship that has been consistent even in the post-crisis environment.

industrial-metals

4. Most post-election factors point to more inflation.

While the market has undergone a significant recalibration post-election, most of the adjustment simply reverses the decline that began in June of 2015 and culminated last February. In this context, the full impact of the election may not be fully discounted. I see significant potential for fiscal stimulus and potentially trade and immigration disruptions, both of which would add to existing inflationary pressures.

Rising rates have hurt the entire bond complex, since a significant portion of the recent rise has been driven by inflation expectations. Still, TIPS have been outperforming nominal Treasuries and because rising inflation has probably not been fully discounted, this pattern may have further to run. As such, I continue to prefer TIPS to the rest of the Treasury market.

Russ Koesterich, CFA, is Head of Asset Allocation for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal. Past performance is no guarantee of future results.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of December 2016 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2016 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

The Latest Risk for Stocks

Inflated balloon surrounded by deflated balloons

Equities continue to grind out new record highs, leaving U.S. stocks expensive relative to both history and other countries. Many investors believe the high valuations are justified given still historically low interest rates and inflation. Unfortunately, the regime may be changing in a way that would be less friendly to elevated equity multiples. One dimension of that change is inflation.

Headline inflation has been rising as oil prices have rebounded. The consumer price index (CPI) is now running at 1.60% year-over-year, double the level in July. This is important for market multiples, which historically have been higher when inflation is lower.

Going back to 1954, the level of the CPI has explained approximately 35% of the variation in the S&P 500’s trailing price-to-earnings ratio (P/E). While the relationship has tended to be less linear with inflation at very low levels, as is the case today, there is another dimension of this relationship that is worth watching: the volatility of inflation.

The relationship between equity multiples and inflation

In the past, equity multiples have been highest when inflation is not only low but stable. Historically, the five-year trailing standard deviation—a measure of volatility—of CPI has explained roughly 30% of the variation in market multiples. The relationship between inflation volatility and multiples holds up even after accounting for the level of inflation. In fact, a model that accounts for both the level and volatility of inflation has explained roughly 60% of the variation in market multiples.

These relationships are important because today inflation is rising and becoming less stable at a time when stocks are particularly expensive. The S&P 500 trades at approximately 20.5x trailing earnings, putting multiples in the top quintile (20%) of all observations going back to the 1950s. Put differently, over the past 62 years the market has only been more expensive roughly 16% of the time. Looking at a longer-term metric, the cyclically adjusted P/E ratio, markets are even more expensive. Based on this metric, which uses longer-term earnings, the market has only been this expensive during the tech bubble or right before the 2008 crash.

cyclically-adjusted-pe

In short, today’s valuations are still supported by low inflation and relatively low rates, but that regime may be shifting. Even if inflation remains low by historical standards, should it start to become unmoored, that would remove another prop supporting equity market valuations. For investors, this suggests two strategies.

First, don’t abandon international diversification. Markets are cheaper outside of the U.S. Second, emphasize more of a bottom-up approach, emphasizing those parts of the U.S. market, notably cyclical companies and health care, where multiples are less stretched.

Russ Koesterich, CFA, is Head of Asset Allocation for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only.You cannot invest directly in an index.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of December 2016 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2016 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Time to Favor TIPS?

Bicycle

Over the past several years, investor perceptions of the U.S. economy have changed dramatically. Following several years of consistently disappointing economic growth, few now expect a return to the post-World War II growth norm.

Amid the sluggish economic recovery, investor expectations for future inflation have also moderated, but perhaps by too much. Indeed, current expectations for future inflation may be too complacent, creating a potential opportunity in long-dated Treasury Inflation-Protected Securities (TIPS).

Shifting the Focus to TIPS

Three years ago, according to data accessible via Bloomberg, investors were expecting inflation of roughly 2.5 percent over the course of the next decade. Even as recently as last summer, expectations for long-term inflation were around 2.25 percent. However, since the summer, inflation expectations have collapsed. As of December 1, 10-year TIPS breakevens, a measure of investor expectations for future inflation, were below 1.6 percent. While this is nominally above the multi-year low reached in late September, it’s well below the long-term 10-year breakeven average of around 2 percent.

The collapse in investor inflation expectations coincides with a similar recalibration among consumers. In addition to measuring consumer confidence, the University of Michigan publishes several surveys measuring consumer expectations for inflation. The most recent survey suggests that 1-year inflation expectations are at 2.7 percent, down from 3 percent in March. The longer-term 5-year survey has inflation expectations at 2.6 percent, just above a multi-year low.

Why have both investors and consumers lowered their expectations for inflation so dramatically? While the sluggish recovery has certainly contributed, there’s some evidence that the precipitous drop in oil has played an outsized factor. Since peaking last summer, U.S. crude benchmark WTI has fallen by approximately 55 percent, according to Bloomberg.

As consumers and investors are constantly exposed to the price of a gallon of gasoline, itself a function of crude prices, the drop in oil may have disproportionately impacted perceptions of inflation. There’s some empirical evidence to support this. Since the third quarter of 2015, the drop in oil prices explains roughly 80 percent of the variation in 10-year inflation expectations, according to a BlackRock analysis using Bloomberg data.

Should oil prices continue to collapse, inflation may remain at today’s low levels or sink even further. However, there are a number of signs that that the recent drop in inflation expectations may be overdone.

Inflation Expectations Underrated?

First, U.S. inflation stripped of food and energy prices, which are inherently volatile, has been much more stable than the headline number. The core consumer price index (CPI), which excludes both food and energy prices, is currently running at 1.9 percent year over year, the highest level since June of 2014, according to data via Bloomberg.

Looking at this from an economic perspective also seems to indicate that today’s inflation expectations may be unrealistically low. My preferred leading economic indicator—the Chicago Fed National Activity Index (CFNAI)—suggests that current estimates for U.S. inflation appear roughly 40 basis points too low.

While I don’t envision a significant surge in inflation anytime soon, I do expect to see some stabilization in inflation and inflation expectations given factors including declining slack in the labor market. In addition, U.S. inflation should firm as the one-off impact of a stronger dollar and lower energy prices start to fade from CPI calculations.

In the meantime, today’s TIPS prices tell me that investors’ inflation expectations may be too sanguine. As such, in bond portfolios, I prefer TIPS to plain-vanilla Treasuries. An allocation to TIPS could help hedge the risk that inflation may be on the rise.

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog.

 

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of November 2015 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2015 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.

iS-17266

Don’t Fret Too Much About the Fed

Fed Benchmark Rate

Janet Yellen, the chair of the Federal Reserve, has said that the Fed is likely to raise its benchmark interest rate sometime this year. Such a move would be the first rate rise since 2006. Whether the change occurs as early as the Fed’s meeting next week or later in the year is still a matter of speculation, but either way higher interest rates could affect your portfolio. So how much should you fret about the Fed’s potential move? The answer is “probably not too much.”

That sanguine answer isn’t because the Fed doesn’t matter. The Fed’s decisions can affect the value of essentially every investment you own. Rising interest rates could increase bond yields and therefore hurt bonds (since bond prices and yields move in opposite directions). They could potentially slow the economic growth rate, hurting stocks. They could strengthen the US dollar compared to foreign currencies, reducing the values of your international holdings as well as causing commodity prices to decline.

But the Fed has been clear about its intentions to raise interest rates for a while. Even Ben Bernanke, the Fed chair before Yellen took over in 2014, had discussed when and how the Fed would raise interest rates. As a result, many of the effects of higher interest rates may have already occurred in anticipation of the Fed’s potential move. For example, it’s likely that some of the gains for the US dollar compared to foreign currencies during the past year (and the interrelated struggles of commodities and emerging market investments) resulted from the possibility of the Fed raising rates.

Furthermore the Fed may not exactly follow the historical playbook this time around. Usually when the Fed starts raising interest rates, they continue with a series of fairly rapid rate rises over the course of a couple years. That pattern occurred in the early 1980’s, the late 1980’s, the early 1990’s, the late 1990’s, and the mid-2000’s. But Yellen has said that this time the Fed plans to raise rates more slowly than usual.

She may not have much of a choice. Developed countries that have raised interest rates in recent years— including Sweden, Norway, and Australia—have had to quickly reverse course when their economies subsequently stagnated. With the inflation rate still below the Fed’s 2% target and a weak global economy, the Fed is unlikely to raise rates very far or very fast.

Inflation Doesn’t Seem Ready for Liftoff

Inflation Rate 2

The inflation rate should be an important consideration for investors. It not only affects the price of many investments—particularly those such as bonds which provide fixed periodic payments—but also how much money you need to reach your financial goals. But for all its importance the inflation rate hasn’t moved dramatically in recent years, and it doesn’t seem likely to start doing so any time soon.

The most commonly used measure of the inflation rate, the Consumer Price Index, was a measly 0.1% in the year through June. That’s far below the Federal Reserve’s target rate of 2% (the Fed technically uses a different measure of inflation, but their measure isn’t much higher). Part of the reason for the low inflation rate has been the plunge in the oil price, which has fallen by about 50% during the past year. But even the inflation rate based on the “core” Consumer Price Index, which excludes food and energy prices and therefore tends to bounce around less, is only 1.8%. It hasn’t touched 2% since early 2013, and it hasn’t touched 3% in almost 20 years.

When will this long period of low inflation end? To gauge financial markets’ expectations about what the inflation rate will be in the future, economists often use “breakeven rates,” which compare regular bonds to inflation-linked bonds. These currently suggest that the inflation rate will remain low, averaging less than 2% per year over the next 10 years.

Such numbers won’t necessarily prove correct, and investors who are concerned about a sudden surge in the inflation rate could use the current period of sanguine expectations to cheaply buy protection against higher inflation (for example with inflation-linked bonds). Yet there are good reasons to think that the inflation rate will remain subdued. Janet Yellen, the Fed chairwoman, recently said that the Fed remains on track to raise interest rates this year. If the Fed starts raising interest rates even as global economic growth continues to slow, the inflation rate may go down rather than up.

What Will the Fed Do with Interest Rates?

Inflation Rate PCE

What the Federal Reserve does with interest rates may sometimes seem like an esoteric guessing game, but it can affect almost every investment in your portfolio. The level of interest rates directly affects the return you can get on cash, and indirectly affects how stocks, bonds, and many alternative investments perform.

Last week the Fed tweaked the wording of its formal policy statement, paving the way for an end to the era of near-zero interest rates that’s lasted since the global financial crisis. Most analysts currently believe this first interest-rate increase will occur this summer. But even if that comes to pass, the Fed isn’t likely to raise rates very far or very fast. At the end of 2015, and possibly for a while beyond that, the level of interest rates is still likely to be very low by historical standards.

One reason interest rates are likely to stay low is the state of the economy. Though the unemployment rate has tumbled from 10% in late 2009 to 5.5% in February, there are signs that the economic rebound is fragile. The Citigroup Economic Surprise Index, which compares economic data to analysts’ prior forecasts, has fallen into negative territory. The surge in the value of the US dollar against other currencies since late last year may also act as a headwind for the economy by hurting American businesses that sell their products overseas.

The current outlook for inflation also suggests that interest rates won’t rise very far. The Fed’s preferred measure of inflation, called the personal consumption expenditure index, is only 0.2%. The “core” number, which excludes some of its more volatile components, is 1.3%. These numbers are far below the Fed’s 2% inflation target. Even if the inflation rate does slightly increase later this year as the effect of lower commodity prices wears off, there doesn’t seem to be much of a threat of high inflation that would force the Fed to take drastic action.

The Outlook for Inflation

Inflation Rate

The US inflation rate has been extremely low since 2009, averaging only 1.6% per year. That’s below the Federal Reserve’s target of 2%. But recently Fed Chair Janet Yellen warned of a phenomenon called “pent-up wage deflation”, which is a complicated way of saying that inflationary pressure could suddenly surge as the economy picks up steam. So how much risk is there of a spike in inflation?

Despite Yellen’s warning, the answer is that a substantial increase in the inflation rate is still very unlikely. Part of the reason is that many of the factors that have kept inflation so low recently are still applicable: with the unemployment rate at 6.1% (and even more people “underemployed”) there remains some slack in the economy, and an aging population should continue to put downward pressure on the inflation rate.

But even if inflationary pressure builds up, it probably won’t lead to a runaway inflation rate. Inflation has been so low for the past 30 years largely because of the actions of the Federal Reserve: after the inflationary surge of the late 1970’s they realized that they could very effectively keep inflation contained by raising interest rates (or simply by credibly promising to do so). The Fed should therefore easily be able to raise interest rates to prevent inflation from significantly exceeding its 2% target.

That doesn’t mean there would be no effect on your investment portfolio. Investments such as bonds (particularly longer-term bonds) that are hurt by higher interest rates would suffer in such a scenario. But the effect of the inflationary pressure would manifest itself in higher interest rates, not in higher prices for the goods and services you buy on an everyday basis. Even if the economy strengthens, an inflation rate near the Fed’s 2% target is still the most likely outcome.

The Possibility of European Deflation

Euro zone inflation rate

The euro zone has struggled mightily in recent years, with its economy shrinking in both 2012 and 2013. Now it faces a new worry. Inflation in the euro zone has fallen to a 0.4% annualized rate, well below the target of close to 2% set by the European Central Bank (ECB) and close to outright deflation. The dangers of high inflation (a sustained rise in the prices of goods and services throughout the economy) are well known: it reduces the value of people’s savings and can make individuals and businesses reluctant to invest. So shouldn’t deflation (a decline in prices) be beneficial? Not exactly.

There are a number of ways that deflation harms an economy. First, since the amount owed on loans and bonds stays the same even if the price of goods and services decline, deflation can make it more difficult for individuals, businesses, and governments that have borrowed money to get out of debt. Just as inflation hurts bondholders, deflation hurts debtors.

Second, it tends to be easier for companies to raise wages than to make their employees take pay cuts. Therefore if prices are declining so companies can’t pay their workers as much, they are likely to lay off more employees, leading to higher unemployment.

Third, when people see prices falling they may respond by postponing their purchases until prices go down even further. A decline in prices can therefore lead to reduced demand, causing further price declines (a “deflationary spiral”).

The euro zone may already been feeling some of these effects, since they can start to kick in when the inflation rate is persistently low, even if it’s still above zero.

Unlike the central banks of other developed countries such as the US, UK, and Japan, the ECB hasn’t engaged in “quantitative easing” (essentially creating new money and using it to buy bonds). This difference is one reason why expected future inflation is now substantially lower in the euro zone than in the US or UK. To avoid the perils of deflation, the ECB may need to take more aggressive action to prop up the continent’s economy.