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Fixed Income Investing

A Perspective on U.S. Inflation and Interest Rates

Christopher J. Molumphy
Chief Investment Officer
Franklin Templeton Fixed Income Group

We think one of the major positives in the current U.S. investment environment is the outlook on inflation. The Consumer Price Index stood at 1.1% year-over-year during June 2010, with trends pointing toward possibly lower inflation levels ahead. More importantly, core inflation, which tends to be a better predictor of future inflation, was just under 1% for the 12-month period ending June, representing a tame inflation level in our view.

This data should not be viewed as a great surprise. In the U.S., inflation is primarily based on slack in the overall economy, particularly with respect to labor markets. For 2010 overall, employment data has reflected a slow improvement in labor markets, but improvement nonetheless. We have seen positive private sector job growth in each of 2010's first six months, though the levels have been markedly small. Given the pace of recovery in employment, we think this also supports a benign outlook for inflation.

The strong likelihood that the Federal Reserve (Fed) will not raise interest rates for the foreseeable future is another positive factor in the current environment. In the U.S., the central bank has a dual mandate to attempt to contain inflation and maximize employment. Both of these factors currently point toward the Fed remaining on hold for some period of time into the future. Looking forward, this should also remain a favorable influence on financial markets.

Should the Fed remain on hold, we would expect short-term interest rates, which are driven by the federal funds target rate, to remain low. Longer-term interest rates, which are primarily driven by inflation, could also remain relatively low given the benign inflation environment. Additionally, an outlook for U.S. economic growth to move toward its historical trend rate of roughly 3%-if not a bit lower-would also be an indicator that longer-term interest rates should stay relatively low.

Last, in periods of global financial market volatility, the U.S.-and the Treasury market in particular-continue to be perceived as "safe havens." Consequently, should we see further bouts of global volatility like that of recent months, rates would likely remain low. In summary, while we are certainly cognizant that long-term interest rates in the U.S. are currently low on a historical basis, we do not see any fundamental data pointing toward significantly higher long-term rates in the foreseeable future.

Looking out longer term, the U.S. deficit concerns us. For the 2010 fiscal year, we anticipate a deficit of about $1.5 trillion dollars, or approximately 10% of gross domestic product. This poses a risk that the financial markets could eventually lose patience with the United States in terms of having the necessary fiscal discipline, but we do not consider this to be a near-term risk.

With the view that fixed income undoubtedly remains core to an investor's overall portfolio, both in terms of diversification and risk reduction, we would also note that there are a number of sectors within fixed income that are driven as much, if not even more so, by factors other than interest rates alone.

Christopher J. Molumphy
Chief Investment Officer
Franklin Templeton Fixed Income Group


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