Inflation Stirs From Its Lengthy Slumber
Well, it isn’t exactly on the order of Rip Van Winkle waking up 20 years after nodding off in the mountains, but after having gone missing over the past few years, inflation seems set to return in 2018. Indeed, over the latter stages of 2017 there were signs that inflation was stirring, to the point that the Consumer Price Index (CPI) increased by 2.14 percent for 2017 as a whole, marking the first time since 2012 that the annual change in the CPI topped 2.0 percent. For the most part, however, this simply reflected the effects of higher energy prices, as core CPI inflation fell short of 2.0 percent in 2017. Perhaps more significantly, the broader Personal Consumption Expenditures (PCE) Deflator, a/k/a the FOMC’s preferred measure of inflation, rose by only 1.7 percent for 2017 as a whole and core inflation, as measured by the core PCE deflator, came in at just 1.5 percent.
To put the depths of the slumber into which inflation had fallen into perspective, only twice in the past 68 months has inflation, as measured by the PCE deflator, been at or above the FOMC’s 2.0 percent target rate while core PCE inflation has not hit this target a single time. To be sure, persistently sluggish inflation has not simply been a U.S. story over the past several years, it has been a global story. Which really should not have been much of a surprise given how much slack remained in the labor markets and industrial sectors of economies across the globe. In the U.S. economy most, though not all, of that slack has been pared down and, with global economic growth having picked up considerably over the past several months, remaining slack is being wrung out of the global economy at a faster pace.
In this environment, the question isn’t whether inflation will pick up, the question is the extent to which it will do so. Most forecasts, including the latest (December 2017) FOMC projections, have headline and core inflation settling at or slightly above 2.0 percent in 2018. Admittedly, even though our model is yielding a similar outcome, we can’t help but think it seems a little too nice and neat to expect that inflation will perk up and then just settle in at or slightly above 2.0 percent. After all, by stubbornly refusing to reach the FOMC’s target rate for so long, inflation has shown it has a mind of its own, so is there really any reason to expect it to suddenly be better behaved on the other side of that 2.0 percent target?
Higher energy prices will be only one of several factors that will fuel inflation pressures in 2018. A weaker U.S. dollar will also add to inflation pressures by making imported goods more expensive for U.S. consumers. While the U.S. dollar began to depreciate against other major currencies in early-2017, that depreciation has gradually picked up pace, and as of January the Federal Reserve’s Broad Dollar Index was down 7.8 percent year-on-year. There is somewhat of a lag between changes in exchange rates and changes in import prices, so while there are few signs of any such “price effects” in the data thus far, it is reasonable to assume these effects will become more pronounced as we move through 2018.
Additionally, the “prices paid” component of the ISM Manufacturing Index hit 72.7 percent in January, the highest since May 2011 – any value over 50.0 percent indicates manufacturers are paying higher prices for raw materials. The ISM’s prices paid gauge has historically had a strong correlation with inflation as measured by the Producer Price Index (PPI), as shown in the accompanying chart. This is also consistent with the signals being sent by commodity prices, which were awakened in 2017 as global economic growth began to firm and which continue to post strong monthly increases.
Finally, as labor market conditions continue to tighten, labor costs will rise at a faster rate, which could also be a source of inflation pressures over coming quarters. As if on cue, the January employment report showed average hourly earnings rose by 0.3 percent in January, yielding the largest year-on-year increase, 2.9 percent, since April 2009. We would caution, however, that this overstates the case. We estimate that higher minimum wages in many states added just over one-tenth of a percentage point to the monthly change in hourly earnings in January, and voluntary bumps in entry level wages by many firms also helped lift hourly earnings. Perhaps more significantly, with average weekly hours having fallen by two-tenths of an hour in January, as harsh winter weather and a punishing flu season significantly impacted hours worked, the estimate of average hourly earnings was artificially inflated. Our point is simply that the wage details of the January employment report overstate the extent of upward pressure on labor costs.
Even so, rising labor costs will be one of many factors stoking inflation pressures over coming quarters. In isolation, none of these factors is overly concerning, but in conjunction they could easily result in inflation accelerating much more sharply than we, market participants, and the FOMC anticipate. We have pegged this as a, if not the, main downside risk to our baseline 2018 forecast, which anticipates three 25-basis point increases in the Fed funds rate in 2018, the first coming at the March FOMC meeting. Faster than anticipated inflation would almost surely prompt the FOMC to raise the funds rate at a faster than anticipated pace, which we think would have potentially significant adverse effects on asset prices and the broader economy. With inflation having awoken from its lengthy slumber, one of the main questions for 2018 is just how refreshed it is. If it’s any consolation, though, we understand the Headless Horseman won’t be making a comeback any time soon.
Source: BEA; BLS; Federal Reserve; Institute for Supply Management.
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