Upside risks to inflation have decreased as a result of US political developments during the first quarter
Developments over the first quarter have prompted us to dial back our assessment of inflation risks somewhat. The odds of a sharp move higher in prices from tariffs must be lowered, while we remain confident that a tightening labor market will push up domestically-generated core inflation in the medium term.
The odds of corporate tax reform, aggressive fiscal stimulus and disruptive protectionist measures have receded, as the administration failed to win sufficient backing in the House and balked at the prospects of triggering retaliatory measures on trade. Risks remain that the administration will attempt to weaken the integrity and independence of the Federal Reserve (Fed) and policy-making apparatus in general. In the meantime the US economy continues to grow faster than potential and generate healthy job creation, while the dollar has retreated and crude prices are showing renewed strength.
We see room for market-implied inflation expectations (i.e., breakeven inflation rates – BEIs) to rise from here, even if the more extreme inflation outcomes are now a little less likely. We anticipate renewed widening in 10-year BEIs from 1.89% at time of writing to 2.15%. The trade is supported by:
- The Trump administration’s policy agenda of immigration controls, fiscal expansion and protectionism, which raises inflation risks;
- Ongoing asset allocation flows into the asset class;
- A gradualist approach to monetary policy normalization, with the central bank tolerating a modest overshoot of inflation – though it will resist the temptation to let inflation ‘run hot’;
- The economy is close to or at full employment, putting upward pressure on wage inflation; and
- Background core consumer price index (CPI) inflation of 2.20% year-over-year, which we anticipate will rise towards 2.25% – 2.50% by late 2017.
Our estimate of increasing core CPI is based on strengthening US economic data. Recent data suggest the labor market is pushing up against supply constraints. The Atlanta Fed’s Wage Tracker index has indicated upside wage pressures for some time (see Exhibit 1 below), corroborating other leading indicators (such as ‘shortage of skilled workers’, ‘jobs easy to get’ surveys, as well as the ‘quits’ rate). Over the last year, average hourly earnings have also begun to rise (see Exhibit 1 below). The overall picture is one of a labor market that is finally hitting up against capacity constraints, which is eliciting a price response.
Exhibit 1: Both the wage growth tracker (compiled by the Federal Reserve Bank of Atlanta) and data for average hourly earnings have indicated upside pressure on wages for some time
Sources: Bloomberg, BLS, Federal Reserve Bank of Atlanta as of 31/03/17
However, US economic developments lead us to believe inflation will rise independent of fiscal policy
The inflation picture is also encouraging. Together with a recovery in commodity prices, higher wages are contributing to pipeline inflation pressure, which is already reflected in Final Demand Producer Price Index (PPI) and the Institute of Supply Management (ISM) Manufacturing survey of Prices Paid. In addition, most measures of core inflation (see Exhibit 2 below) have demonstrated gains over the last 18 months.
Exhibit 2: Changes in measures of core inflation (i.e. Consumer Price Index for all urban consumers or CPI-U) and inflation in the cost of services show rising trends over the last 18 months
Sources: Bloomberg, BLS as of 28/02/17
Domestic price pressures are building for a number of reasons, including labor market capacity constraints, the recovery in commodity prices, and above trend GDP growth
Core Personal Consumption Expenditures (PCE), at 1.8% year-over-year in February 2017, rose slightly faster than the FOMC’s forecast, and looks set to be at its 2.0% target by late 2017. Furthermore, the treatment of administered medical costs, which has been influenced by ObamaCare, has been a transitory headwind for core PCE. Core CPI, meanwhile, is running at 2.0% year-over-year, but we note that the trend in services inflation is upwards (see Exhibit 2 above), meaning that inflation is no longer only supported by rising shelter costs. That is very encouraging, and confirms that domestic price pressures are building.
We forecast that the US economy will grow at 2.10% in 2017 and 2.0% in 2018, depending on the net fiscal boost delivered by the Trump administration. These forecasts remain highly tentative at this stage, given the uncertainties on fiscal policy, monetary policy response, trade policy and the currency. Nevertheless, these 2017 and 2018 forecasts represent growth rates that are above our 1.5% estimate of trend growth, and would therefore further reduce unemployment and drive up domestically-generated inflation. We anticipate that PCE inflation should reach 2.0% by the end of 2017 and 2.25% by the end of 2018. The risks to our view are that the US dollar moves sharply higher, the Federal Open Market Committee (FOMC) turns unduly hawkish, or the economy suffers an external shock.
Written 17 April 2017