US Watch – What’s up with inflation?

by: Bill Diviney

  • Core inflation continues to disappoint to the downside, despite an
    apparently tight labour market
  • While some transitory factors are at work, and base effects should
    push core PCE back near the Fed’s 2% target by year-end…
  • …low unit labour cost growth makes it unlikely we will see a
    significant acceleration over the next 18 months
  • Prolonged subdued inflation is leading to inflation expectations
    becoming unanchored
  • Concern over this is one of the main reasons we expect the Fed to
    cut rates, regardless of the outcome of trade negotiations
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Inflation is, once again, becoming a key concern for investors and policymakers.
Indeed, while increased uncertainty linked to trade policy is the primary driver of
the Fed’s dramatic dovish shift, ‘muted inflation pressures’ were explicitly cited in
the June FOMC statement as a reason for the Committee to ‘act as appropriate to
sustain the expansion’ (code for rate cuts). Since the beginning of the year, CPI
inflation has repeatedly disappointed to the downside, and core PCE inflation is
running below the Fed’s 2% target at 1.6% (see Appendix on p6 for differences
between CPI and PCE measures). Even more concerning for the Fed, there are
signs that longer term inflation expectations are becoming unanchored, raising the
urgency to act to prevent below-target inflation becoming entrenched. In this note
we explore the drivers of the inflation undershoot, and the prospects for a recovery.


The return of ‘temporary factors’

To an extent, the undershoot in inflation of the past half year is indeed driven by
some transitory factors. First, and most often cited, is the change in data collection
methodology for apparel. This involves the tapping of big data sources, with
manual survey-based data replaced with a direct feed from a department store
chain. Apparel has a 4% weight in the core CPI and has been 0.1pp drag on
inflation since the start of the year, though it is unclear how much of this is due to
the methodological change. Ultimately, the Bureau of Labor Statistics expects up
to 32% of the index to be fed by big data in future, but it remains to be seen
whether future changes will have moderating or amplifying effects on inflation.

An even bigger drag has come from transportation services, and within that
category, car insurance premiums. This category was a significant boost to
inflation in 2018, following dramatic hikes to premiums after the devastating
damage from hurricanes Harvey and Irma in 2017. As these effects unwound, the
decline in transportation services inflation has meant a 0.2pp drag on annual core
inflation.The final notable drag on inflation has come from drugs prices. The Trump
administration has been on a drive to accelerate the approval of generics and this
has weighed heavily on prices. Indeed, annual drug price inflation turned negative
on a sustained basis for the first time in over 45 years last December, and has
remained mostly negative since then. This has subtracted approximately 0.05pp
from core inflation over the past year.

Temporary factors will fade, but underlying inflation is muted

At the very least, the impact of the fall in car insurance premiums, and some of the
drag from apparel linked to the methodology changes should gradually fade. The
impact of generic drugs approvals could persist as more come to market, though
this drag should remain modest given the small weighting (just 2% of core CPI).
However, looking beyond these components, core services inflation remains
remarkably muted given the tightness in the labour market and the corresponding
pickup in wage growth. Indeed, wage growth has accelerated a full percentage
point over the past 2 years, from c.2% to c.3%, yet core services inflation has
actually fallen back recently. Why is this?

The answer lies with productivity growth. After many years of subdued rates of
growth, productivity has picked up markedly over the past few quarters, from
around 1% on average for much of the post-crisis period, to 2.1% on average over
the past two quarters. This has in effect paid for the acceleration in wage growth,
as unit labour cost growth actually fallen. While the drivers of productivity growth
are complex, we think this largely reflects higher rates of investment over 2017-18
of 6.1% on average, up from 1.1% over 2015-16. Indeed, the tight labour market
seems to be encouraging employers to raise productivity as an alternative to hiring
new staff (there have been anecdotal reports of this in the ISM surveys).

As such, while base effects should push core PCE inflation back up near the 2%
target by year-end, broadly speaking we expect inflationary pressure to remain
subdued for the foreseeable future – at least on our forecast horizon to end-2020.
Even if productivity growth falters and unit labour cost growth starts accelerating
again, the lack of pricing power in a globalised market, and still-elevated profit
margins, means that businesses are likely to (initially at least) take the hit to
margins before passing on costs to consumers. This should keep core inflationary
pressure contained.

Inflation expectations becoming unanchored

Against the backdrop of low inflation and elevated risks to the growth outlook,
market-based inflation expectations (5y5y forward breakeven) have declined
considerably, from 2.1% as recently as April, to 1.8% in recent weeks. A bigger
concern is the decline in more stable survey-based measures, and in particular the
Michigan consumer survey. In June, 5-10y expectations fell to 2.2% – the lowest in
the survey’s 40 year history. While such a number might not seem like much to
worry about given the Fed’s target is 2%, as a survey-based measure this is likely
to be inconsistent with 2% realised inflation. To illustrate, the last time core PCE
inflation was at the Fed’s 2% target on a sustained basis was in 2008, when the
Michigan survey-based measure averaged 3.1%. As such, a 2.2% reading from
the Michigan survey likely corresponds with a core PCE rate below 2%.

It appears, then, that the prolonged period of subdued inflation is leading to
expectations becoming unanchored. At a time when the Fed is actively examining
policy framework changes that would raise inflation expectations1, this
development should be particularly worrisome to FOMC members. Expectations
are hard to shift once they become entrenched, as they often feed into wage
expectations, creating a self-fulfilling dynamic. Indeed, Fed Chair Powell voiced
concern over the possible de-anchoring of expectations at the June FOMC press
conference, while more dovish members of the Committee such as James Bullard
and Neel Kashkari have explicitly cited the fall in inflation expectations as a reason
to cut rates.

Lowering our inflation forecasts

As a result both of the transitory factors weighing on inflation, but also the
weakening in pipeline pressure from lower unit labour cost growth and the decline
in inflation expectations, we are lowering our core inflation forecasts. The bulk of
this is visible in our forecast for core PCE, which we have lowered by 0.2pp in both
2019 (to 1.7%) and 2020 (to 1.9%), as the higher weight of shelter in the CPI to
some extent blunts the weakness in inflation elsewhere (see Appendix). Should
these forecasts be realised, PCE inflation will have undershot the Fed’s 2% target
for eight out of the ten years to 2020, while core PCE will have undershot for all ten
of those years. While the size of the undershoot is not as severe as has been
observed in other developed markets such as the eurozone and Japan, the
asymmetry in the target miss, combined with the fall in inflation expectations is a
cause for concern.

Muted inflation bolsters the case for rate cuts

We expect the Fed to cut rates a cumulative 75bp by Q1 2020, starting at the July
FOMC meeting with a 25bp cut. The principal driver for this is the trade war reescalation,
which – even with the recent truce – has significantly raised uncertainty
for business. This is weighing heavily on investment, leading us to downgrade our
growth forecast for this year and next to 2.2% (previous: 2.3%) and 1.5% (1.9%)
respectively.

However, the weakness in inflation and the decline in inflation expectations
bolsters the case for easing even further, and is one of the reasons why we expect
rate cuts regardless of the truce in the US-China trade war.