Inflation and inflationary pressures are emerging in the U.S. economy. A plethora of measures from the real economy, the financial markets, and numerous surveys all show inflation starting to bubble up. While it is unlikely that broad-based inflation rates will rise significantly above 3% for an extended period of time, it is likely that the economy this year will break out of the less than 2% range experienced since the end of the recession. We are now factoring in new information (the recent increase of oil prices in particular) to revise on the upside our US inflation scenario to 2.8% y/y on average compared with 2.3% y/y before
Real economy points toward higher prices alongside higher capacity utilization
Measures of inflation in the real economy have recently risen significantly.
No single measure will rise in a straight line every month of course, but the number of measures indicating rising prices is striking:
- The Personal Consumption Expenditures (PCE) Price Index and the PCE core index, which excludes the volatile food and energy components, have both risen 60 basis points (bps) since August including a 30 bps increase from February to March. Perhaps more importantly the PCE core is now rising at 1.8% y/y, bumping up right next to the Fed’s target of 2% for this measure.
- Consumer and Producer Prices, including their core components, have also risen sharply over the past year, and all four measures are now above 2% y/y.
- Housing prices in the past 12 months have risen at an average y/y rate between 5.6% (NAR existing median sales price) and 6.1% (Case-Shiller, 20 cities SA). And since the end of the recession, 6.9% and 6.2% respectively, far outpacing wage gains of only 2.3% over the same period.
- Some essential commodity prices are on the rise. Lumber prices have risen 60% since last August when it became clear that the administration was about to impose a 21% tariff on Canadian softwood. Steel prices, such as those on Midwest Hot-Rolled Coil, have been pressured by tariffs and have risen 35% since January. Commodity indexes such as the S&P GSCI Commodity Index have risen 18.7% y/y.
- US retail gasoline prices have almost increased by 20% y/y in June.
- Freight rates, which lead other prices and the economy in general have risen a steep 12.8% y/y as measured by the Cass Freight Expenditures Index
- Wages are being pressured by a number of indicators in the tight labor market, including a job openings/unemployed ratio of 1, a high quits rate, and aggressive hiring plans expressed in the National Federation of Independent Business (NFIB) survey. As a result the Employment Cost Index (ECI) Wages and Salary component rose at an annualized rate of 3.7% in Q1-18, the most in 11 years.
Chart 1 CPI and PCE headline and core rate
Chart2 Lumber and Steel prices, Cass Freight Expenditures Index
Surveys point toward higher inflationary pressures as well
Surveys across a range of industries are also reporting inflationary pressures
- The Institute of Supply Management’s (ISM) manufacturing survey, which indicates expansion when it is over 50, has ten components, one of which measures prices paid for inputs. That measure reached a seven year high of 79.3 in April. The same measure for the non-manufacturing survey reached a five year high last September and remains at an elevated 61.8. A separate semi-annual survey noted that in December, manufacturing respondents forecasted that prices would rise 1.3% in the first four months of 2018, but in actuality prices rose at a much faster 4.8%. Respondents are currently forecasting price increases of 5% for all of 2018. On the non-manufacturing side, the current forecast for all of 2018 is 2.1%.
- Regional Fed surveys are showing rapid price increases in the manufacturing sector. The Philadelphia Fed’s “prices received” index reached a 29 year high in May. The “prices paid” index reached a seven year high, and the New York Fed’s prices received and prices paid indexes reached seven and six year highs respectively.
- The National Federation of Independent Business (NFIB) survey of smaller businesses reports pricing pressures across a wide range of industries. The net percentage of respondents raising prices rose to the highest in almost 10 years in May.
Inflationary pressures and expectations have been emerging in financial markets.
Long-term interest rates reflect both inflationary expectations, and the “real” interest rate which is driven by current supply and demand.
The yield on the benchmark 10 year U.S. Treasury note recently rose above the 3% psychological barrier, and reached 3.11% on May 17th, the highest in almost seven years.
The real rate, as represented by a Treasury Inflation Protected 10 year security reached a seven year high on the same day.
Inflationary expectations as represented by the spread between a regular 10 year and a TIP reached the highest in almost four years
What does our model tell us?
In order to factor in the recent evolution of macroeconomic variables (in particular higher energy prices), we have updated our US inflation model.
This initiative is important given our belief that the Federal Reserve could be more aggressive than previously expected in tightening US monetary policy. Our methodology consists of decomposing the headline CPI index into its main subcomponents (core commodities, medical services, shelter services, transportation services, education, food and energy), building a forecast for each of them, and then re-combining them to create a forecast for the headline index. Other explanatory variables used in our model include oil prices, the unemployment rate, the Dollar Index, average hourly earnings, real GDP growth, the Fed Funds target rate, and the budget deficit. We assume a forecast for the price of Brent crude oil of USD 76 per barrel at the end of 2018, and an average price for all of 2019 of USD 69 per barrel. Taking into account all these elements, we obtain a scenario where US CPI inflation reaches a peak of 3.3% y/y in July 2018, followed by a rapid decline thereafter. For all of 2018 we expect CPI to average 2.8% y/y, and for all of 2019, 2.1% y/y. By comparison our previous forecast was for 2.3% y/y and 2.4% y/y, respectively. Despite the upward revision for 2018, we are not changing our assumption about Fed monetary policy, because the surge in prices will only be temporary. In addition, a simple Taylor rule supports our scenario for 2 more rate hikes in both 2018 and 2019.