Inflation indicators have been creeping up. Most notably, in February the personal consumption expenditures (PCE) deflator rose 2.1% year over year (y/y), passing the 2% threshold for the first time in almost five years.¹ The Consumer Price Index (CPI) is up 2.7% y/y in February, continuing a steady climb higher after an oil-induced drop in early 2015.²
Yet higher inflation does not necessarily translate into higher interest rates, and income-starved investors are likely to remain hungry in 2017. The markets continue to price in a measured trajectory of two more Fed rate hikes this year, and I agree.³ It is important to take a fresh look at the underlying drivers of inflation to better understand the potential impact on future monetary policy.
When we use broad inflation measures to take the temperature on inflation, the mercury barely rises to lukewarm:
- The CPI has been on an uptrend for the past two years as base effects from the late 2014 decline in oil prices work themselves out of the headline measure. The consensus expects CPI to level out at 2.4% y/y by the end of 2017.4
- Core CPI, which excludes the volatile food and energy components and gives a clearer picture of underlying price trends, is up 2.2% y/y. Over the past five years, core CPI has held a remarkably steady range, averaging 1.9%.5
- Critically, other measures of inflation paint an even more benign picture. The PCE deflator is the broadest measure of inflation and is favored by the Fed. When you hear the financial press talk about the Fed’s long-run inflation target of 2%, they are talking about the PCE deflator. Yet the core PCE deflator has been below 2% for years.6
At the same time, price pressure is heating up in certain segments of the economy. Services prices have been a consistent and significant driver of upward pressure on inflation. Shelter prices account for about a third of consumer prices, and rose 3.5% y/y.⁷
Offsetting upward price pressure from services has been falling goods price inflation, which has been on a steady downtrend since the mid-1990s. Goods prices make up 19% of the index and were -0.5% y/y in February.⁸
The bottom line is that while headline inflation indicators are off their post-recession lows, they are not yet running “hot.”
The bigger picture
Inflation has long been the boogeyman for monetary policymakers, and when they check under the bed – which they do frequently – they look for much more than the headline inflation numbers. The Fed distinguishes between inflation driven by structural changes in one sector and inflation that is fueled by the entire system of our economy. This is important to understand: Upward price pressure from policy-related changes in one sector (for example, rising medical care costs, which averaged 3.9% inflation in 2016), will not be significantly impacted by a Fed rate hike, because it is not an outcome of a strong economy or the tight labor market. The Fed is less likely to see medical care cost inflation in and of itself as a reason to accelerate their rate hike speed.
What the Fed is really on the hunt for, and looks to kill, is an inflationary wage-price cycle, which the figure below illustrates. Prices rise enough for consumers to expect higher inflation and incorporate those expectations into their wage negotiations. Higher labor costs lead to increases in the cost of production for producers, which gets passed on to consumers through higher prices. And so on. This is the classic cycle that sparked inflation of over 12% in the 1970s and 1980s, and again, although to a lesser extent, in the late 1990s. The danger of sparking systemic wage-price cyclical inflation is significantly greater when the unemployment rate is low, as it is right now.⁹
The missing link
Currently, the missing link in this chain is wage inflation. Average hourly earnings growth averaged 2.0%10 from 2010–2015 and it has begun a gentle uptrend, with March earnings up 2.7%.11 The employment cost index – the broadest measure of compensation – was up only 2.2% in the fourth quarter of 2016.12 So far, wages have not accelerated appreciably and remain below long-run averages.13
The Fed’s 2% inflation target is more of a guide than a firm threshold – it will take more than a PCE deflator above 2% to cause the Fed to step up its rate hike schedule. Without accelerating wage inflation, we expect the Fed to remain cautious and focus on other areas of the economy that need support. After all, GDP in 2016 was only 1.6% and business investment remains weaker than confidence indicators suggest. We expect the search for yield to continue to challenge investors in this low interest rate landscape.