US inflation breaking higher? - Westpac

Elliot Clarke, Research Analyst at Westpac, suggests that market inflation expectations for the US economy have trended higher over the past two years, but this has been as much about the pricing-out of deflation risk as it has been the inflation outcomes themselves.

Key Quotes

“It has only really been in the past six months that inflation has shown a sustained lift to target. This occurred after the labour market reached (and exceeded) ‘full employment’ in early 2017.”

“The January CPI report therefore comes at a pivotal time, with market participants seeking to discern whether inflation will remain contained at or near target, or breakout above.”

“The headline monthly outcome of 0.5% was the strongest since early 2013 and obviously well above target if annualised. However, annual growth was unchanged at 2.1%yr.”

“A large contributor to inflation in the month, and indeed over the past six, has been energy prices. In January, the energy index rose 3.0% as gasoline prices gained 5.7%.”

“Highlighting the degree to which oil has changed the US inflation narrative over the past year: the six months to July 2017 saw annualised headline inflation of just 0.2% as energy prices fell 12%; but in the subsequent six months, headline inflation rose 4.1% as energy prices surged 28%. Herein we see that a key contributor to the uptrend in headline CPI inflation, and indeed the only reason it is currently above the 2.0%yr target, is a global supply shock.”

“That being said, there has also been a noticeable acceleration in core inflation (ex food and energy) towards the medium-term target. Having recorded a 1.1% annualised gain in the six months to July 2017, core inflation has since accelerated to a 2.6% pace in the most recent six months.”

“More importantly, within the core components, there are pockets where demand is driving (or at least allowing) inflation.”

“Despite an 11% fall in the US dollar (DXY basis) over 2017, there is no obvious signs of imported inflation. Apparel prices rose 1.7% in the month, but are still down 0.7% over the year. Similarly, new vehicle prices are 1.2% lower over the year; and, as a result, used vehicle prices are broadly flat.”

“All of the detail considered, we conclude that inflation is on the rise in the US, but a breakout that would pose a risk to our policy expectation is not yet in sight. It is worth remembering that the FOMC focuses on the PCE measure of inflation not the CPI. Core PCE inflation is a little further from target, at 1.7% in six-month annualised terms to December and 1.5% over the year. This offers a greater degree of comfort to the FOMC and means they can maintain their ‘gradual’ approach to policy normalisation. This is likely to see three hikes in 2018, followed by another two in 2019.”

“To see a true inflation scare (i.e. inflation threatening to materially exceed the 2.0%yr target), both activity and wages growth will have to accelerate sharply. While we expect GDP growth to jump in 2018, it will be due to business investment and government spending, both of which should boost capacity and limit inflation. Wages are likely to rise only modestly, not ramp higher.”