Will Goldilocks Inflation Stay in 2019?

Not Too Hot, Not Too Cold but Just Right

Inflation has reached a Goldilocks state as far as the Fed is concerned. Both headline and core PCE inflation are up 2.0% over the past year, exactly in line with the FOMC’s target. That follows six years in which the core—the FOMC’s preferred barometer of trend inflation—undershot the committee’s goal. Multiple bouts of disinflation, like in 2015 and again in 2017, had many questioning whether the Fed’s 2% goal was achievable (Figure 1). The FOMC pressed ahead with normalizing anyway, but at a historically slow rate. Further tightening has continued on gradually as inflation has firmed without showing signs of becoming unhinged. Yet could the Goldilocks scenario change and cause the Fed to either quicken its pace of policy tightening or ease up on the brakes?

In a report last year, we focused on five specific inflation surprises for the upcoming year. This year, we take a more thematic approach and look at the factors we view as most likely to lead inflation away from its current sweet spot of 2.0%. While we see a number of scenarios that would cause inflation to veer either above or below 2%, we believe that ultimately, solid U.S. growth and upward pressures from tariffs will push core PCE inflation to 2.2%. That would be moderate enough to where the Fed is likely to hike a few more times next year. But where might things go wrong?

Upside Risk I: Capacity Constraints Come to a Boil

The United States is on course for one of, if not the, best years of the current expansion. Strong growth alone is not sufficient for inflation, but 2018’s solid performance registers at a time when there is very little excess capacity in the economy. Given inflation’s tendency to lag growth, the economy’s impressive performance this year may only now be starting to rev up inflation. Capacity constraints are particularly evident in the labor market, where the unemployment rate is already below “full employment.” Job openings are near record highs, while finding qualified labor is small businesses’ single most important problem. Wages are rising as a result. While still modest compared to the later stages of previous cycles, research suggests that the relationship between unemployment and wages is nonlinear.

The pass-through between wage costs and inflation may not be as strong as it once was2, but there is still a positive link between a tight labor market and inflation. Labor is the largest cost for most companies, particularly in the service sector, which accounts for 75% percent of core inflation. With order books full and companies seeing take-home pays rise as they cut bigger checks to their employees, businesses may be emboldened to raise prices. The share of businesses that is raising compensation and prices has jumped over the past year to the highest level of the expansion.

The tighter labor market and increased willingness for firms to raise prices is part of our baseline call for modestly higher inflation next year, but a steepening of the Phillips Curve and/or faster tightening in the labor market may lead inflation to rise more strongly. That could lead the FOMC to tighten rates faster and/or more than the three quarterly 25 bps hikes in our current forecast.

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