Ahead of the Curve: Pushing the dovish pivot – the US inflation story

Article originally posted by Hermes Investment Management on 25 February 2019

Following the US Federal Reserve’s (Fed’s) dovish pivot last month, a significant pick-up in inflation is probably the only development that could justify a resumption of US tightening. Given the muted US inflation readings seen so far in this cycle, such a shift seems unlikely which raises broader questions about the relationship between labour market slack and prices in the US economy (the Phillips curve framework). In her latest Ahead of the CurveSilvia Dall’Angelo, Senior Economist at Hermes Investment Management, assesses the factors shaping the US inflation story in 2019 and beyond.

A puzzlingly-low picture

In recent years, the US economy has been operating above potential and the labour market has tightened, yet inflation has remained well contained. Core personal consumption expenditures (PCE) inflation – the Fed’s preferred gauge of underlying inflation – briefly touched the central bank’s 2% target in mid-2018, but quickly resumed a downward trend, ending the year at 1.9%.

Well-contained inflation was cited as a key contributor to the Fed’s dovish turn in last month’s policy statement, as chair Jerome Powell flagged that muted inflation readings, combined with the recent drop in oil prices, may push inflation lower still. As downside risks from adverse external developments and volatility in financial markets are elevated, the Fed now faces a tough hurdle to resume its hiking cycle.

Modest pressures

Hermes analysis suggests that US inflationary pressures will build up modestly in 2019, reflecting the ongoing tightening of the labour market, but they will likely remain contained.

Silvia Dall’Angelo, Senior Economist, Hermes Investment Management: “From a top-down perspective, a Phillips curve-like model suggests that core PCE inflation will probably edge up to 2% this year, from 1.9% in 2018. Meanwhile, core consumer price index (CPI) inflation – which usually runs a few tenths above its analogue PCE measure – will probably increase to 2.3% on average over the year, up from 2.1% in 2018.” In a recent paper, the Federal Reserve Bank of San Francisco contended that inflation has not sustainably reached the central bank’s 2% target1. Its analysis showed that most of the increase in PCE inflation towards the Fed’s target can be attributed to acyclical factors – types of changes in prices that do not necessarily move with overall economic conductions – and are not due to a strengthening economy.

Moreover, inflation expectations appear to have stabilised at somewhat lower levels since the global financial crisis. This trend is reflected in all of the main indicators, both survey- and market-based. Although it is not easy to map indications from surveys and markets into numerical implications for actual consumer inflation, lower inflation expectations imply a weaker pull towards the 2% target.

Dall’Angelo, continued: “A bottom-up analysis largely confirms the message from our top-down approach: there will be a limited build-up in inflationary pressures, stemming from the recent small increase in wage inflation and the impact from higher tariffs on some categories of goods (notably, recreation). That said, housing inflation – which has a large weight in both core CPI and PCE – has moderated recently, while forward looking indicators – notably, rental vacancy rates – point to a stabilisation in rent inflation, at best.”

Beyond the headline: core inflation

Thus far, our analysis has focused on core inflation – that is, inflation that excludes the most volatile components (energy and food items). After all, it is the more persistent component of inflation and over time, headline inflation tends to converge to core inflation (indeed, past core inflation is a better predictor of future headline inflation than past headline inflation).

However, the Fed’s target is defined in terms of headline inflation. By adding energy and food to our analysis, the inflation picture for this year becomes even more contained. Oil prices, which fell sharply in the fourth quarter of 2018, have a significant impact, and the forward curve for oil implies only modest variations to Brent prices at about $60-65 per barrel over the balance of the year.

By taking account of the oil curve, our forecasts point to an average rate of US headline PCE inflation of 1.6% in 2019 (corresponding to headline CPI at 1.8%). Of course, oil prices can swing quite wildly, and a resurgence of geopolitical risk – notably, concerning Iran – or a policy shift by the Organisation of the Petroleum Exporting Countries (OPEC) could lead to very different outcomes.

US inflation prospects: protectionist risks

Beyond 2019, cyclical and structural factors point to a benign inflation picture in the US. From a cyclical perspective, we expect that US growth will slow over 2019 to about 2% on average, down from almost 3% last year. In addition, recession probability models suggest that there is about a 30% chance of a recession in the next 12 months – the highest level since the global financial crisis. Amid growing risks and higher vulnerabilities, a downturn in 2020 looks likely. In this scenario, capacity constraints would likely loosen, implying weaker inflationary pressures.

“On a structural level, we have long argued that structural changes in the labour market may explain the current environment of low inflation. Factors such as technology (automation), globalisation and increased market concentration have probably all contributed to those changes”, said Dall’Angelo.

In the medium to long term, technology probably has some way to go to influence inflationary dynamics via its impact on the labour and product markets. Indeed, automation and artificial intelligence (AI) have the potential to cause deep and long-lasting disruption to the labour market, and a gradual transition to a new equilibrium would probably feature significant dislocation and replacement of the labour force. Such technological disruptions will probably have disinflationary effects, at least during the initial adjustment phase.

Dall’ Angelo, concluded: “In the short to medium term, the main risk to our benign picture of inflation is a re-escalation of protectionist measures, which could lead to higher inflation, but the unwelcome sort – that is, cost-push rather than demand-pull inflation. Thus, the Fed would probably look through it, giving more consideration to the negative income effects from higher inflation and the likely squeeze to demand that would follow.”

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