Is the US reflation trend faltering?

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One disappointing data point can be dismissed as a blip, but two could be the start of an unwelcome trend for US reflation.

US core inflation fell by 0.1% month-on-month in March, when it was dragged down by steep cuts in telecommunication prices.

Data released on 12/05/17 showed core inflation rose by 0.1% versus the previous month. This was a distinctly smaller rebound than expected by the market and the detail in the report was not encouraging.

These two consecutive weak months are likely to exert downward pressure on the annual reading for the rest of the year and the overall breadth of the weakness in the report suggests the rate of inflation may be shifting to a softer trend.

Exhibit 1: Changes in the headline US consumer price index and the core consumer price index for the period from 2005 through 15/05/17

Source: Bloomberg, BNP Paribas Asset Management as of 15 May 2017

Core goods and services remain in deflation territory

Trends in the prices of core goods remain firmly in deflation territory and have been joined in recent months by slowing core services inflation. The US Federal Reserve (the Fed) has said that it will look through the weakness in first-quarter GDP growth data, which it sees as transitory, but will the back-to-back weakness in the core consumer price index (CPI) give the monetary policy committee reason to pause the gradual tightening? After all, this weakness should carry over into the Fed’s preferred inflation gauge, the core personal consumption expenditure index (PCE). In that event, a PCE reading of 1.5% year-on-year (YoY) in April would make it unlikely that the measure could reach a pace of 1.8% by the year-end as the Fed projected it would as recently as its March policy meeting.

Exhibit 2: In core goods the trend of price developments remains unequivocally in deflationary territory and the rate of inflation in core services is now decelerating (the graph shows changes in the level of core goods and core services inflation in the US over the period between 2000 and 15/05/17)

Source: Bureau of Labour Statistics, BNP Paribas Asset Management, as of 15/05/17

There’s no doubt that US labour markets are tight, with slack continuing to diminish. The Fed’s expectation is that this will eventually spark (wage) inflation. If it doesn’t, the Fed is likely to further revise lower its estimates of the unemployment rate at which the rate inflation will accelerate, also known as the the NAIRU (non-accelerating inflation rate of unemployment).

Alternatively, the Fed may consider that the rate of US inflation is more a function of global factors than solely domestic US trends.

In either case the implication would be a more gradual pace of rate rises. At the moment we are not ready to change our view that the Fed will raise interest rates again in June. Nor is the market – expectations for a June rate rise remained high at close to 100%.

In our opinion the Fed is keen to exploit opportunities to raise rates in order to bring them back to a more neutral policy setting and dispose of some leeway with regard to its main monetary policy tool. It may also be that the Fed has taken some comfort from a rebound in retail sales in April and upward revisions to the February and March data. So far there’s been no hint from the Fed that the case for a rate hike in June is under review but forthcoming speeches will be scrutinised for any sign of wavering.

Written on 16 May 2017

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