Will US inflation undershoot the Fed’s target?

by: Maritza Cabezas

150227-US-inflation.pdf ()

Some Fed policymakers are showing concerns about commencing tightening in a low inflation environment. Cheaper oil and its effects have been putting downward pressure on inflation. We expect to see some further decline in headline inflation and flattish to slightly lower core inflation in the next few months. Meanwhile, we expect core inflation in the longer term to stabilise as the downward effect of the decline in oil prices will be transitory and overall demand in the economy will continue to strengthen.  We therefore think that core inflation will start to move towards the Fed’s 2% target later in the year, reaching it during 2016. Our base scenario is for a rate hike in June. We see, however, some downside risks for lower core inflation in the coming months which could delay the Fed’s decision to hike rates.

 The Fed’s inflation target recently under pressure

With the labour market strong, the Fed’s mandate of maximum employment is on the right track. On the other hand, some Fed members are concerned about the impact that cheaper oil, a stronger dollar and global disinflation could have on their other mandate of a longer-run inflation objective of 2% inflation. This long-run goal is a result of the lag with which monetary policy actions tend to influence economic activity and prices. Fed policymakers have a preference for core measures of inflation, which exclude changes in the more volatile food and energy prices. The Fed actually forecasts the core index of personal consumption expenditures (PCE) and not the CPI. This is largely because PCE covers a wider range of household spending. Core PCE inflation has been relatively steady in the past year, but turned slightly softer in the past few months and is at just over 1.3% yoy now.


Alternative core inflation measures also soft

Although the FOMC forecasts the PCE, it looks at alternative core inflation measures for its monetary policy decisions. For instance, Fed policymakers also look at the Dallas’s Fed “core PCE trimmed mean measure”, which has almost halved to 0.7% in December 2014 from 1.22% in December 2013. This indicator excludes a chosen proportion of unusually large and small price changes before the average is computed, which makes it less volatile. This method excludes a good deal more than food and energy. The trimmed mean has proven to be a better estimator of core PCE. On top of this Fed officials look at the subcomponents of core inflation to see if they are the result of one-off events or temporary factors. Since the recession core inflation, core PCE and the core trimmed mean measure have been undershooting the Fed’s 2% target.

US CPI target

 Decomposing core inflation

What has been driving core inflation? While shelter (rental) costs have been slowly picking up since the recession ended, core services and core goods have been slowing. In the past years, shelter costs were largely influenced by the expanding number of lower-income households, facing a constrained supply of rental homes. As for core goods, these have been relatively low in the past years. The largest contributor to the decline has been transportation, mainly used vehicles. In the case of core services some of the decline is explained by lower medical costs.

US CPI core

Some FOMC members concerned about inflation outlook

Although January’s FOMC statement was more firm regarding the future inflation path, the minutes of the January FOMC meeting that followed showed concern among some members about commencing tightening at a time when inflation is running below 2%. Indeed, we now know that some participants would like to see stable or rising levels of core PCE inflation, or alternative series, to restore their confidence that underlying inflation will return to the 2% target. Furthermore, the discussions around the decline in market-based measures of inflation expectations showed that a number of FOMC members wanted more evidence that this decline did not constitute grounds for concern.

 Incoming inflation data critical for the policy outlook

Fed policymakers have expressed the need to see further data. We think that they will be searching for more evidence of a pick-up in wage growth, while the dollar appreciation should remain at tolerable levels for the economy. Our base scenario considers a modest appreciation of the trade-weighted index in the coming time. Moreover, there are still a few inflation reports before the Fed’s March FOMC meeting, in which a better sense of direction about policy normalisation are expected.

 But how likely is a further fall in core inflation?

With the labour market strong the Fed policy will depend on how the inflation outlook develops. In the short term core inflation will be flattish in our view. In fact we see a gradually increasing path for core inflation late in the year, in line with stronger domestic demand, which would bring core inflation closer to the Fed’s 2% target during 2016. Indeed, evidence from the past suggests that when core inflation declines significantly, contributions from shelter, core goods and services usually fall simultaneously. This is not the case now. We even still see some upside in shelter costs, but we see some downside risks in the pass-through of a stronger dollar and a more rapid decline in import prices, particularly for core goods prices which are already weak. As for core services prices, of all the categories this may be the hardest to predict. Wage growth, one of the sources for upward price pressure in core services, will gradually pick up.

 The upside: modest wage growth not a strong impulse yet

The impact of wages on inflation is not straightforward in the short run, but most FOMC members expect that diminishing slack in the labour market will be helpful in returning inflation over the medium term to the FOMC’s 2% target. Until recently, wage increases were subdued, despite the falling unemployment rate over the past year. We think that the unemployment rate will continue falling to around 5% and that the equilibrium rate of unemployment is around this level. This means that at this rate, wage inflation would accelerate, albeit at a moderate pace. It will likely take some time, though, for this to filter through to service prices, but at least the past weakness of nominal wage growth will not gradually pick up. In fact, in time we expect that service prices ex rent and energy will return to their path of above wage growth.

US CPI and wages

The more temporary upside: shelter costs

We expect the upward pressure on shelter costs to continue for some time. The rental vacancy rate has been moderating, and continued to decline in 2014. Although this rate should eventually rebound as the supply of rental homes catches up there is still some room for further declines in the short run. We think that growth in rental construction will be slow and it may take around a year for rental prices to ease.

The downside: stronger dollar,…

The stronger dollar has been putting downside pressure on import prices excluding petroleum, but the impact on core goods inflation is less clear. Indeed, although there is a strong link between the dollar and the prices of non-petroleum imports, evidence suggests that in the US the pass-through channel to consumer prices from import prices is not very strong. Indeed, according to Fed research, the pass-through from a strong dollar to non-petroleum import prices is about  -0.5 over the past five years[1]. This research suggests that the relationship between import prices and consumer good prices is, however, weaker and has shown little common movement. We have seen that although there is an initial impact, after a few months the impact tends to fall. The Fed study concludes, however, that situation of global inflation could enforce this pass-through. This explains partly why the Fed has included global disinflationary pressures as one of the risks to the international outlook in its last minutes.

US CPI  import prices

…and lower commodity prices

This brings us to one of the drivers of global disinflation: lower commodity prices. Commodity prices have trended lower, reflecting moderate economic growth and increasing supply in many commodity markets. The above factors have seen global manufactured goods prices falling in the past few years. While we expect oil prices will gradually increase by the end of the year, we expect the impact of lower oil prices will dissipate only slowly.

For some Fed officials, a concern is that some measures of longer-term inflation expectations are closely linked to oil price trends. Any tendency for these longer-term inflation expectations to drift lower or even to fail to reverse over time could have troublesome implications for the inflation outlook. We think that in order for lower inflation expectations to change into persistent low inflation, such expectations would need to trigger a lower wage-price spiral. Given that US labour market slack is diminishing, we don’t see this as a serious risk in the near term and we expect inflation expectations will eventually stabilise.

Our view on the inflation and Fed policy outlook

In the long run we expect a slowly increasing path for core inflation in line with stronger domestic demand, which would bring it closer to the Fed’s 2% target later this year, reaching it in 2016. We forecast flattish to slightly lower core inflation in the short run, but there is a risk that this could fall slightly as a result of more downward than upward pressure. Our base scenario is for a rate hike in June 2015. There is, however, a chance for the Fed to move slightly later this year. Fed policymakers are also evaluating the trade-offs of a too late or too early lift off, citing staying too long at the lower bound risks an undesirably high inflation. Moreover, they mentioned that if they tried to correct this rapidly if necessary, this could adversely affect financial stability. We are convinced that the Fed can’t wait too long as zero interest rates look increasingly inappropriate in an economy firing on all cylinders. A gradual approach in hiking interest rates will likely be the preferred option.

US up and dow pressure

[1] Bednar W. and Knotek E. Global Factors and Domestic Inflation, Cleveland Fed, September 2014