Fundamentals side with Fed on inflation

Angst about the near-term outlook for U.S. inflation is beginning to show as some regional Fed presidents who on net lean hawkish have voiced their concerns.

Recently, Atlanta Fed President Raphael Bostic said the acceleration in inflation could last longer than previously thought, and he labelled “transitory” as a dirty word. He is correct that this bout of inflation could persist a little longer than previously thought as the Delta variant magnifies issues in the global supply chain. That and the recent jump in energy prices will both be inflationary.

However, we remain comfortable with our forecast for growth in consumer prices to moderate next year.

The Fed appears to be keeping a close eye on a couple of things to assess whether transitory inflation is turning into something worse. The minutes from the September meeting of the Federal Open Market Committee note that many participants pointed out that the owners’ equivalent rent component of price indexes should be monitored carefully since rising house prices could lead to upward pressure on rents.

One month isn’t a trend, but monthly growth in owners’ equivalent rents posted an above-trend gain in September and further acceleration next year is likely as the CPI for rents lags other measures of rents. Though rental inflation will accelerate next year, we expect this to be more than offset by disinflation in those components of the CPI that have been contributing the bulk of the recent runup, including vehicle prices and those components sensitive to the reopening of the economy.

Also, a few FOMC participants noted there was not yet evidence that robust wage growth was exerting significant upward pressure on prices, though the possibility merited close monitoring. Strong growth in average hourly earnings has been garnering a lot of attention, but average hourly earnings are not the best measure of wage growth. We don’t put a ton of emphasis on them given the measurement issues.

Our takeaway from all the wage data we track is that wage growth has begun to moderate, though some believe this moderation is due to difficult year-over-year comparisons.

This is visible in our wage tracker. In statistical jargon, the measure is defined as the “first principal component” of six wage measures: the employment cost index, average hourly earnings, unit labour costs, the Atlanta Fed Wage Growth Tracker, median usual weekly earnings, and our Current Population Survey-based wage estimate.

Our wage tracker suggests that growth has decelerated recently with year-over-year growth falling below 2%. To confirm that this is not all due to difficult comparisons, annualised growth in our wage tracker remains within the range seen throughout most of the last expansion, suggesting no evidence of a wage-price spiral taking hold.

This supports the Fed’s transitory view and explains why central bank policymakers are not in a hurry to start discussing raising the target range for the fed funds rate.

The recent rise in market-based measures of long-run inflation expectations hasn’t spooked Fed officials, nor should it. The minutes said several participants noted that market measures of inflation expectations were still in ranges broadly consistent with the Fed’s long-term inflation objective.

Market-based measures of inflation expectations have risen recently, but when adjusted for the historical gap between the CPI and PCE deflator, inflation expectations are still consistent with the Fed’s new policy framework of average inflation targeting. Still, five-year, five-year forward inflation break-even rates are at 2.3%, up 20 basis points over the past month.

Inflation swaps have also been on the move; the five-year, five-year forward inflation swap is now at 2.56%, up 19 basis points over the past month. Also, five year forward inflation break-even rates are following global oil prices; the 52-week correlation coefficient between the two is currently 0.85, at the high end of the range seen over the past few years.

Fluctuations in oil prices have a temporary effect on realised inflation and inflation expectations, so the Fed won’t be losing any sleep.

Economic roundup

The U.S. consumer price index rose a little more than we anticipated in September, but it didn’t alter our high frequency GDP model’s estimate of third-quarter real GDP growth. Our highfrequency GDP model still has third quarter GDP on track to rise 2.6% at an annualised rate.

Risks are weighted to the downside and our tracking estimate could drop later this week with the release of September retail sales. The forecast is for control retail sales, which feed into the Bureau of Economic Analysis’ estimate of real consumer spending, to have declined 0.2% in September, compared with the consensus for a 0.5% gain. If our forecast is correct, it will reduce our tracking estimate of fourth-quarter real consumer spending.

Turning back to inflation, the CPI rose 0.4% in September following gains of 0.3% in August and 0.5% in July. The non-reopening components of the CPI such as housing, food and energy were behind the rise in the CPI and suggest that price pressures are broadening.

Components of the CPI, including lodging away from home, vehicle rentals, and airfares along with admissions to sporting and other events that are sensitive to the reopening of the economy, subtracted 0.04 percentage point from the September CPI after subtracting 0.1 percentage point in August.

Vehicle prices, which had been providing a big boost to the CPI, were also neutral in September as the gain in new vehicle prices were offset by the drop in used-car prices.

Declines in used-car prices may end in October; the Manheim used-car index has risen recently.

The core CPI was up 0.2% in September, in line with our forecast. September’s gain puts the core CPI up 2.7% annualised over the prior three months, compared with the 5.4% gain in August. The core CPI was up 6.6% annualised over the prior six months, a touch less than the 6.8% in each of the prior two months.

Odds are that inflation temporarily accelerates in October and November as the impact of higher energy prices bleeds into consumer prices.