Don’t be surprised if inflationary pressures build up steam as the economy gets increasingly constrained by the supply side
In the weeks after the Fed raised interest rates in December, global financial markets trembled and inflation expectations, as measured by the bond market, declined significantly. On February 9, market-based inflation expectation over the next five years fell to just 0.93 percent, the lowest level since the Great Recession. This drop in inflation expectations fueled calls for halting the rate hikes, with a growing cohort of economists and market participants questioning the wisdom of raising rates in the first place.
Thus far, however, actual inflation numbers have refused to cooperate with the winter’s bleak expectations. Both major core inflation measures—core consumer price index (CPI) and core deflator of personal consumption expenditure (PCE), the measure favored by the Fed—have accelerated significantly in recent months; the 12-month growth rates of core CPI and core PCE now stand at 2.3 and 1.7 percent, respectively. (See chart.)
But is it really surprising that inflation is not remaining at its subdued rates of well below two percent? We don’t think so. The main story in the U.S. economy right now is that it is gradually running into supply constraints, which by definition implies price pressures in the labor market and later on in goods and services.
Despite declining energy and commodity prices and cheaper imports due to the strong dollar, the current inflation environment is not far off from the Fed’s 2-percent target. Most consumer spending is in domestic services and housing –sectors relatively little impacted by currency or oil prices. Moreover, healthcare and housing prices have been accelerating over the past year. (Incidentally, the CPI weighs housing and healthcare much more heavily than PCE, which is the main reason why the two measures have diverged so much in recent months.)
So, what do we then make of the deviation between market-based inflation expectations and actual observed prices in recent months? And what does the data tell us about inflation in the future?
First, we should take reports of very low and falling market-based inflation expectations with a grain of salt. The gap between regular bonds and inflation-indexed bonds can often be distorted by extraneous factors, especially during times of market turbulence. The Great Recession offers a case in point; in November 2008, five-year inflation expectations reached a low of −2.2 percent, which clearly turned out to be far below reality.
That said, inflation is likely to remain low through 2016, with core PCE probably remaining below 2 percent (although the core CPI is above two percent). Several reasons are behind this: First, wages are only just beginning to accelerate and their impact will remain limited this year. Second, the ripple effects of lower oil and commodity prices are still moving through the supply chain, putting downward pressure on consumer prices. Third, the strengthening dollar is likewise still not fully reflected in consumer prices.
However, we should not be complacent about inflation risk, simply because there wasn’t much of it in recent years. In fact even later this year and in 2017 it could be a different story. If, as The Conference Board projects, the U.S. economy is still growing at around 2 percent in 2017, accelerating labor costs will start being passed on to the consumer. Meanwhile, the inflation-limiting effects of a strengthened dollar and lower oil prices will have mostly evaporated by then.
Many doubt that we should be worried about inflation with GDP growing at just 2 percent. But we argue that when planning for 2017, it is completely justified to be more concerned. As we have been warning since 2014, the U.S. faces a perfect economic storm: Baby-boomer retirement is a generational tidal wave that combines with very weak gains in labor productivity to set up a situation of historically low growth on the supply side of the economy.
This was not evident when the job market was still inching tortuously toward recovery. But as the unemployment rate approaches its natural level, the supply-side constraints are becoming binding. Going forward, today’s fast pace of employment growth will be difficult to sustain without creating serious wage pressures and, eventually, higher inflation.
The markets may be recognizing this as well. Five-year market-based inflation expectations have jumped from 0.93 percent on February 9 to 1.43 percent on April 5th. It is quite likely that inflation, even core PCE, will rise to levels that the Fed is uncomfortable with while economic growth remains mediocre. Indeed, don’t be surprised to see the Fed act on inflation fears and sooner than the dovish view in its last statement would suggest.