Question

What assumption makes it ok to assume the market prediction for inflation is the best guess.

Answer 1

In general terms, If inflation reaches 3%, the Federal Reserve may have to accelerate its timetable for raising interest rates. Bond yields will rise to compensate investors for the loss in purchasing power. Mortgage rates will tick higher. The present discounted value of all dividend and corporate earnings will be trimmed, and the stock market to the degree that it is partly rational will experience some level of correction. Inflation as measured by the Consumer Price Index has been lying dormant for the past five years, averaging only 1.3% per annum. Modest price pressure arose last year, however, and the most recent CPI inflation in February advanced by 2.1%. The following are the conditions which makes it ok to assume the market prediction for inflation is the best guess-

1. The unemployment rate is low, and will trend even lower. Economic textbooks say that once employment is full with the unemployment rate at around 5% or so, then any further tightening in the labor market will put upward pressure on wages and consequently on prices. In February, the unemployment rate was 4.1%. There is no recession on the horizon. Unemployment insurance filing is at historic lows, and the number of job openings is at historic highs. The unemployment rate will surely head lower.
2. America is swimming in high levels of wealth. The boom in the stock market, combined with steadily rising home prices, boosted the combined net worth of all households to a record high of $98.7 trillion at the end of 2017. To be sure, wealth distribution has become unequal, but anyone with some exposure to the stock market and to real estate has improved financially. Real estate net worth (home value minus amount of mortgage owed) held by households reached $14.4 trillion, an all-time high and more than double from the recent cyclical low point in 2010. High wealth means more confident consumer spending and consequently added pressure on retail prices. Even if there is a 10% correction in value, the net worth is still way up there.
3. Oil prices will not collapse. Energy and gasoline prices have been rising at a near double-digit pace in recent months and at a minimum we will not see a price decline in that sector. The U.S. economy is in no danger of a recession, but this is also the case with many countries across the globe. The strengthening global economy will require greater energy usage.
4. Rents and home prices will continue to move ahead at a good clip. There is a shortage of housing in America due to significant underproduction of new homes over the past decade. In normal times, around 15 to 17 million new housing units would be built over a decade to accommodate rising population and to replace obsolete units. In the last 10 years, only 8.8 million new homes were built. This shortage cannot be fixed quickly. That means rents and home prices will easily continue to rise by at least 3%, as has been the case over the past five years (technically, home prices are not part of the Consumer Price Index, as homes also represent a financial investment. What is included is something called a “homeowners’ rent equivalence” that attempts to measure what a homeowner would pay in rent for their home).

Many other factors can move inflation one way or the other. For example, trade restrictions may mean higher prices for toys and shoes. Plenty of rain and good harvests can keep food prices manageable, while a drought can do the reverse. Distribution efficiencies by online retailers like Amazon could hold prices down. A shortage of truck drivers could boost the cost of transportation. More people seeking work after having been out of the labor force will boost labor supply and hold wages from accelerating too fast.