The markets were caught off guard at the end of January by a pickup in wages. Then came trade tariffs that likely will push up import prices. And oil recently breached $70 a barrel. The effects of tax cuts and increased government spending are also coming down the pike. Inflation hawks are becoming increasingly concerned. They will be watching the Federal Open Market Committee’s meeting June 12–13 to see whether these developments trigger a more aggressive tightening trajectory from the Federal Reserve.

Yes, inflation is moving higher, according to a number of broad measures. Those measures include the Fed’s favorite, the Personal Consumption Expenditures Price Index, which continues to approach its 2% target level. (That gauge has only rarely and briefly done so since the Fed instituted an explicit target in 2012.)

But higher isn’t the same as high.

No cause for alarm

In the outlook for 2018 that we published late last year, our economics team listed an inflation surprise as the greatest risk to the status quo. Global growth was becoming more synchronized at a time when 80% of the world’s major economies were already at full employment, and commodity prices looked set to rebound off recent lows. The result, we explained, was high odds of a cyclical upturn in inflation in the United States and abroad—something the markets weren’t pricing in at all.

Don’t confuse the cycle with the trend

A cyclical uptick in inflation, even if it temporarily overshoots 2%, wouldn’t cause the damage that hawks fear—a decline in the dollar’s purchasing power or an imminent hike in longer-term interest rates, which could undermine the relatively high prices of stocks and other assets.

Longer term, we expect the economy’s growth and inflation prospects to remain subdued relative to historical standards, as does the Fed—see its forecasts in the figure below. 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. (For a deeper discussion of inflation, see Vanguard’s Global Macro Matters paper From Reflation to Inflation: What’s the Tipping Point for Portfolios?)

Those aren’t forecasts that should set inflation alarm bells ringing.

The Federal Open Market Committee’s current economic projections

Note: Median projections, data as of March 21, 2018.

Sources: The U.S. Federal Reserve System and Vanguard.

What might “more aggressive” look like?

We will have to wait for the Federal Open Market Committee to release its statement at the close of its June meeting to glean how the Fed is interpreting the latest economic data. (An increase in the federal funds target rate to a range of 1.75%–2.00% is widely expected at the meeting.)

Our outlook on the Fed’s interest rate plans remains the same: three hikes in 2018 and three in 2019, taking the fed funds rate ultimately near 3% before stopping and, by 2020, perhaps even a cut in rates. 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. This is a differentiated view, as was our view that the Fed would be “emboldened” to raise rates this year as unemployment rates continued to drop. So far, on point.

Whatever the change, it won’t alter our longer-term market outlook. We continue to urge investors to remain disciplined and globally diversified, armed with reasonable return expectations and low-cost strategies. 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.


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