By Victor Yeung
The latest economic numbers show that inflation in the United States remains benign. After Hurricane Harvey has disrupted the oil refining hub in Texas, oil prices have risen by more than 15%.
Watch inflation numbers for interest rates trajectory
However, September’s consumer price index (CPI) was only 2.2%, versus the consensus estimate of 2.3%. The core CPI of the month, at 1.7%, is also lower than the 1.8% estimated by analysts.
The mild CPI numbers suggest that inflation pressure remains manageable in the United States.
Tracking inflation numbers in the US is crucial because it is the major determinant of how quickly interest rates will go up.
The most basic justification of interest rate increase is that we are now in a period of exceptionally low rates, and the Federal Reserve should increase rates to prepare for any future economic shock.
Thus, today’s situation is different from that of other cycles, when the Fed was lifting interest rates to slow down inflationary pressure.
Seeing the current rate increase cycle is akin to fixing your roof during the summer when the weather is good, and thus, the Federal Reserve can slow down or stop rate increases if there is a need.
The more benign inflation is, the more likely the Federal Reserve will continue its rate hike at a measured pace.
Technological advances tend to determine economic outlook
The current economic recovery is correlated to several key technological advances.
It started with the large-scale deployment of shale gas and oil projects, which increased US oil production for the first time since the 1970s.
After that, the investment in various green technology is beginning to pay off. Large-scale adoption of these technologies has increased the amount of GDP generated by each unit of energy.
Energy is a key input to any economy, and thus a steady, long-term increase in efficiency will reduce inflationary pressure.
For example, oil consumption levels in the US peaked in 2008 and are now roughly 10% lower, with the total consumption in 2014 below that in 1997.
While some of the decreases can be attributed to the previous recession, improved efficiency in cars allowed consumption levels to remain steady even as economic growth begins to pick up.
Efficient energy key to satisfying global consumption
Current pilot programs, such as a recent program that adds solar panels to heavy-duty trucks, continue to make efficiency gains.
Also, solar power is getting to a point that it can impact the overall system. In the US, the cost of a solar panel has fallen by 90% since 2010.
For an average family in Southern California, for example, a rooftop solar panel can pay itself back in three years, before government subsidies.
That compares favourably to the situation in 2010 when the same system took eight years to pay back even after taking into account of government subsidies.
Additionally, battery technology has also improved enough that solutions such as Tesla’s power wall systems can complement a solar panel system to support a home system throughout the day.
Since a solar panel system does not require fossil fuel in its day-to-day operation, a larger scale adoption of solar power will also directly reduce demand for coal, oil and gas. This would further reduce inflationary pressure.
Productivity another key
Some other technologies are also deflationary because they improve productivity. Currently deployed apps such as Uber and Airbnb allows the society to utilise underused resources.
Piloting artificial intelligence apps will assist white-collar workers in their work, unlocking more capability.
The energy and productivity technologies will make this economic upcycle less inflationary than the ones before it.
And thus, we do not think the previous rule of thumbs and “gut feeling call” of rate normalisation speed make senses.
We believe that investors, especially those close to retirement age, should build their investment portfolio with an expectation that while rate will increase, the speed at which it increases can be surprisingly slow.
Investors should obviously treat rate increase as a factor and not invest all their capital in rate sensitive assets, but they also should be conscious of the fact that cash yield may improve only slowly.