US inflation has been running below the Federal Reserve’s targeted 2% goal for a few years, although Fed Chair Janet Yellen is optimistic that it will reach its target rate in the medium-term. What is the outlook for inflation, and Fed rate hikes, and the implications for plan sponsors and investors?
John Pliner, director and portfolio manager, Towers Watson Investment Services, New York, believes the US inflation market is “under discounting upward pressures on inflation and interest rates” in the next couple of years, given the higher-than-trend growth, reduced capacity, and rising wages. And according to Dipesh Bhise, chief investment officer, Mooring Financial Corp., Vienna, Va., “The 10-year Treasury rate is a modest 2.25%; the bond market is not factoring in much inflation or rate increases. In other markets as well, investors are assuming low rates for longer and are pushing up asset prices across the board.”
In addition to inflation expectations, and the usual suspects such as uncertainty around oil prices and the dollar’s foreign exchange value, Yellen has articulated other reasons for why there is uncertainty around the Fed’s outlook for inflation. These include uncertainty around the amount of labor market slack, the possibility of continued subdued growth in health care prices, the impact of global integration on prices, and reduced margins for retailers as a result of competition from the growth of online retail.
Pliner expects that transitory factors such as cheaper cellphone and drug prices will not be an impact beyond early 2018. Tightening labor markets will have more of an impact in the medium-term, he expects. And Bhise, while seeing a role for all of the factors cited by Yellen, noted, “Technology is playing a big role in the downward pressure on prices. Whether it is online retail, transportation efficiencies, or increased automation, they all have the effect of lowering prices of goods and services.” Alan Perry, a principal and senior investment consultant with Milliman in Wayne, Penn., also sees the “sharing economy” as playing a role in keeping inflation down.
Inflation prospects are likely to influence both corporate pension plan sponsors and public pension plan sponsors. Corporate pension plans use long-term bond interest rates to discount their pension plan liabilities. According to Perry, “To the extent that the bond market is looking at inflation expectations and changes in inflation expectations, and what the Fed does, the impact of inflation and inflation expectations on long-term interest rates is the whole ball game for them.” Corporate pension plans also tend to have significant allocations to equities, while their fixed-income investments typically tend to have shorter durations than their liabilities’ durations. This means that, to the extent longer-term interest rates rise, they stand to benefit considering that their liabilities will decrease more than any losses they might incur on their bond investments.
In this scenario, if equity markets perform well, too, and don’t have a big correction as long-term rates rise, Perry sees these corporate pension plans as emerging “big winners,” considering that their liabilities will fall, their assets will not fall as much, and their funded ratios will go up. He observed, “That’s a bet that a lot of them have been making and holding on to, for whatever reason, year after year after year. But interest rates have not gone up, they have mostly gone down. And I think some of them are just determined for some reason or another to keep that bet in place until they win.”
In the case of public pension plans, inflation would impact their pension payouts, which typically have a cost-of-living adjustment, and their liabilities. If their system’s actuary decided they needed to raise their assumptions for long-term inflation, considering that these plans discount their liabilities based on the long-term expected return on their portfolios, while their benefits payments would rise, that would be offset by the rise in the discount rate. However, if sudden changes to the inflation outlook upsets the markets, and causes corrections in equities and bonds, that could have an unfavorable impact on their funded ratios immediately.
So, what is the inflation outlook for the near future and how will it impact the outlook for the Fed funds rate? Bhise doesn’t see any significant change in inflation for the near future, noting that the Fed’s own projection calls for 1.9% PCE inflation in 2018, and 2% for 2019 and 2020. For September, actual PCE inflation was only up 1.6% from a year ago, with core inflation rising 1.3%. And Pliner noted, “We continue to believe that medium- and long-term market implied inflation is too low, consistent with the Fed’s missing its inflation target for a protracted period. We expect inflation and inflation expectations to rise towards target over the next two years, given tight labor markets.”
The futures markets are anticipating one more rate hike by the Fed this year, and a gradual two hikes for 2018. Perry noted, “My take on the Fed is that their balancing act is to raise short-term rates enough to give investors confidence that they are on the job in terms of controlling inflation. They need to raise rates just enough to convince the bond market that they are on top of things and not going to let inflation and inflation expectations run away from them.”
Tags: corporate pension plans, Federal Reserve, Inflation, Janet Yellen, Pension