Data released by the US Department of Commerce on 30 August showed that headline and core (excluding food and energy) personal consumption expenditure (PCE) inflation rose by 1.4% and 1.6% respectively in July, year-on-year. So core PCE inflation continues to sit at around 0.40% below target, supported mostly by robust shelter inflation, while core goods price inflation hovers at around zero (despite the imposition of tariffs on a now broader range Chinese imports) and (pro-cyclical) non-shelter services inflation remains muted despite evidence of pipeline pressures and a tightening labour market.
Core personal consumption expenditure (PCE) is considered the most important inflation measure for the US Federal Reserve's (the Fed) policy decisions. Over the last 10 years, core PCE has tended to err on the low side of the Fed's target of 2.0 % year-on-year. The index has remained below target throughout 2019 despite low rates of unemployment.
Exhibit 1: Weak inflation - US core personal consumption expenditure (PCE) inflation rose by 1.6% in July, year-on-year
Weak inflation data remains a puzzle
The limited sensitivity of procyclical component inflation to changes in labour market slack remains puzzling, as much to the Fed as to investors. Suggestions that companies do not have pricing power and must therefore absorb higher costs into their margins are at odds with evidence of margins being high in many industries. An alternative explanation may be that productivity, after many years of stagnation, is now growing faster than official measures suggest, which may be keeping unit labour costs contained.
A more sobering thought is that inflation is failing to respond to tighter resource utilisation because inflation expectations have become unanchored from the target and are moving lower (a thesis consistent with inflation expectations surveys and market-based measures of inflation compensation taken from the TIPS market). New York Federal Reserve President John Williams voiced this in a speech in July when he noted that "investors are increasingly viewing these low inflation readings not as an aberration, but rather as a new normal."
We expect inflation to rise eventually, provided the Fed is patient
Our view is that core inflation will ultimately respond to tighter resource utilisation, but only as long as the Fed is convincing in its stated aim to drive inflation back to target on a sustainable basis. This will require the central bank to continue to allow the labour market to run ‘hot’ for a while.
Markets expect another Fed rate cut in SeptemberAccording to the federal funds futures contracts, markets are pricing a 93% probability that the Fed will cut its benchmark interest rate by another 25bp at its next policy meeting on 17-18 September.
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