The economic picture in the US has changed relatively little: solid above-trend growth driven by consumption (boosted by labour market strength), resurgent business investment (driven by an absence of spare capacity, a lower corporate tax rate and deregulation) and a significant fiscal impulse. A benign outlook for inflation could be upset by the effects of tariffs on imported Chinese goods, but this should be a one-off. Longer-term, however, a drop in trade would be inflationary.
First-quarter GDP data showed that the US economy grew by 2.0% on an annualised basis. The chart illustrates the primary contributors to growth. At the time of writing*, the Atlanta Fed’s ‘Nowcast’ model indicated that Q2 GDP growth would be 3.8% quarter-over-quarter, annualised.
Exhibit 1: US gross domestic product (GDP): main contributors
Source: BEA, as of June 2018
Labour market: still waiting for wages to accelerate
Turning to the labour market, solid payroll gains of around 200 000 a month (using the February through June data) have continued and the U3 unemployment rate dipped from 4.1% in March to 4.0% in June, while the U6 underemployment rate fell to 7.8%.
Wage data, however, indicated that compensation pressures remained largely dormant. Other than average hourly earnings (AHE) and the employment cost index (ECI), a broad range of indicators suggested that the labour market was approaching supply constraints. Yet, although the U3 unemployment and U6 rates fell to 4.0% and 7.8%, YoY AHE growth was at 2.7% – barely higher than a year ago. In part, this may be due to people re-entering the labour force, reflecting hidden slack.
The Atlanta Fed Wage Tracker measure, which adjusts for compositional biases, similarly failed to move higher. In fact, the tracker indices suggested wage growth might have slowed in recent months.
In our view, it is just a matter of time before we see confirmation of this trend in the Fed’s favourite measure of compensation rates, the ECI. Still, the muted response in wages is somewhat of a puzzle, and it is worth noting Fed Chairman Powell’s comments on 6 April that “the absence of a sharper acceleration in wages suggests that the labour market is not excessively tight.”
Whether the labour market is tight or whether the Phillips curve is simply flat, our conclusion is nevertheless that wages are not (yet) accelerating higher and that the pass-through to the consumer price index (CPI) is likely to be modest.
Exhibit 2: Atlanta Fed Wage Tracker: year-over-year wage gains for prime-age workers (12-month)
Inflation: what about the effects of the tariffs?
Inflation developments have been distinctly uninspiring, with the last three core CPI releases printing at 0.18%, 0.10% and 0.17% MoM. However, base effects meant that the 12-month rate for core CPI did increase to 2.21%. These base effects should help 12-month core and headline inflation to rise to 2.3% and 3.0%, respectively, by the July release, before falling back again.
Exhibit 3 provides a heat-map of monthly changes in the major CPI components. It is worth noting that the hurricane effect that had supported used vehicle prices in Q4 2017 and Q1 2018 seemed to have subsided. Furthermore, the surge in medical care costs in Q1 did not carry through into Q2.
Exhibit 3: Monthly CPI changes (month-over-month)
Source: St. Louis Fed, as of June 2018
In summary, we expect 12-month headline inflation to recover due to base and hurricane effects through mid-2018 before falling back by year-end. The reality of a flat Phillips curve means that underlying core inflation will likely return to target only gradually.
One source of upside risk to our benign inflation outlook, though, comes from the tariffs on Chinese imports. While tariffs could push up goods prices, the impact would be one-off in nature. Indeed, beyond the initial tariffs, the economic disruption caused by a trade war could be expected to be disinflationary in the medium term. The longer-term implication of a world with less trade, however, would be to drive inflation higher.
*This article is an extract from the Inflation Linked Bond report for second quarter 2018.
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