US Watch – Inflation: Not too hot, not too cold

by: Bill Diviney

  • Inflation in the US has recovered more quickly than anticipated, driven by core goods and housing
  • Some of this strength will likely persist, but structural forces continue to weigh on the medium-term inflation outlook
  • The cyclical labour market story is also not a clear-cut positive: participation is recovering, and the NAIRU could be lower
  • We have raised our 2018 core CPI inflation forecast by 40bp to 2.1%, but do not see signs of a significant pickup from here
  • ‘Just right’ inflation should keep the Fed comfortable with its gradual rate hike path
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Updating our forecasts

Notwithstanding a weak April print, inflation has been surprisingly firm in the US so far this year. The core CPI (ex-food and energy) has risen on average 0.20% mom since January – well above the monthly average pace of 0.15% since 2010. On an annual basis, and helped by favourable base effects, core inflation picked up from 1.8% yoy in January, to 2.1% in March and April. In this note, we delve into some of the drivers of the recent strength in inflation, and more importantly, make an assessment of how sustainable the recent pickup is. While we continue to think core inflationary pressure will remain broadly subdued, the strength early in the year has led us to raise our 2018 forecasts, for CPI by 30bp to 2.4%, and core CPI by 40bp to 2.1% (forecasts on an annual average basis). We are also publishing forecasts for PCE and core PCE inflation for the first time. For headline PCE inflation, we expect 2.0% this year, and 2.1% next year. For Core PCE inflation, we expect 1.9% this year, and 2.0% next year. While these numbers are somewhat higher than previously expected, they will not be a concern for FOMC members, coming as they have after a prolonged period of below target inflation. The table below summarises our forecasts and changes.

What has driven core inflation higher?

In taking stock of inflation developments, it is important to distinguish between base effects – which explain much of the annual rise in inflation – from higher frequency developments, which have pushed up monthly inflation. Of the c.40bp increase in year-on-year core CPI inflation, around half is due to an unwind of base effects from 2017’s dramatic drop in mobile phone tariffs, which weighed on inflation for much of last year. Of the remainder, around 10bp is because of higher shelter inflation, with a further 10bp from a reduced deflationary drag from core goods – namely apparel and used cars (c.5bp each).

This is corroborated by an analysis of contributions to month-on-month inflation, which shows that shelter and apparel have been stronger not just compared to
the same period last year, but also to longer term average price growth. Used cars had been stronger in the first three months of 2018, but this unwound rather dramatically in the April inflation print, when prices fell 1.6% on a seasonally adjusted basis. Medical care services have also been somewhat stronger, though this has been partially offset by weaker prescription drugs inflation.
Shelter and goods have driven strength in inflation Base effect from mobile phone tariff drop unwinding
pp contribution to month-on-month core CPI inflation Wireless telephone services, % yoy (lhs) & pp contribution (rhs)

  

Some of the cyclical strength in inflation will likely persist

Some of the strength in inflation has unwound, but pressures continue to build from core goods, given the continued rise in commodity prices – which has in part been driven by tariffs (and in some cases the fear of tariffs, with anecdotal evidence of ‘panic buying’ of steel and aluminium for instance ). While we expect a limited impact from any potential import tariffs (see here), and the run up in commodity prices – led by oil – may have peaked (see here), the lagged passthrough of earlier increases nonetheless poses continued upside risks to core goods inflation.

We had flagged potential strength in core goods this year (here) – which exhibit a lagged relationship with commodity prices – but we underestimated the strength in shelter inflation. Shelter inflation had cooled during 2017 as a higher home ownership rate appeared to be putting downward pressure on rental inflation.

  

While home ownership is likely to continue recovering as the labour market strengthens further, it is unlikely to reach pre-crisis levels, given structural constraints such as higher student loan debt among millennials (which limits how much mortgage debt they can take on), and much higher credit standards, which have been in place since the subprime crisis .

But structural drags remain…

Although we have raised our forecasts for this year and next, we believe structural downward pressure on inflation remains, including from globalisation and technological progress. A prime example of this is last year’s mobile phone tariff fall, which was not driven by lower prices per se, but improvements in service quality, driven by technological improvements. The likes of ecommerce, autonomous cars, and other applications of artificial intelligence are likely to continue to dampen inflationary pressures in the coming years. Indeed, both globalisation and technological change are arguably behind the structural deflation in core goods since the 1990s. While core goods is seeing some cyclical pickup at present, this is unlikely to be sustainable in the medium term.

…and there could be hidden labour market slack

Furthermore, the labour market may not be as tight as the low unemployment rate suggests. First, unit labour cost growth remains weak, and with investment picking up, there remains potential for a rebound in productivity growth to offset cost pressures from higher wage growth. Second, there are signs of a cyclical improvement in labour force participation, with the participation rate for prime age workers finally recovering. This would act as a brake on the the fall in unemployment, even with strong jobs growth. Third, the rate of unemployment at which wage growth (and in turn inflation) more meaningfully accelerates – the NAIRU – could well be lower than it was in the past. One reason for this could be that the average education level of the workforce is higher than in the past, and unemployment tends to be lower among higher educated cohorts – perhaps because such groups are better able to adapt to structural shifts in the labour market (eg. the decline in one industry vis-à-vis another). This was a view expressed by ‘a few’ FOMC members at the March meeting.

  

Conclusion

Inflation has recovered more quickly than we anticipated, though not because of the factors one would expect at this stage in the cycle – namely labour market tightness. As such, while it gives the Fed greater confidence to continue gradual rate hikes (we expect five 25bp hikes at each press conference meeting to June 2019), we do not view it as a sign that inflation is on the verge of picking up significantly. For a sustained pickup, we believe we would need to see a meaningful recovery in unit labour cost growth – something that still appears some way off.