What's behind the persistently low inflation that could drive the Fed to cut rates this year? A host of factors suggest the Fed's 2% target for inflation is overly optimistic.
- We see no compelling reason to share the Fed’s optimism that inflation will soon be 2% or higher.
- If the Fed implements a change to start using average inflation targeting, as it has been discussing, we think the case for lower rates this year is even more compelling.
- Faster nominal spending growth that would make either sustained higher inflation or sustained higher economic growth has failed to occur.
- There have been pronounced slowings in a number of prominent components of inflation, and there is reason to think that these could be sustained.
- The longer observed inflation rates stay at or below the current range, the more pressure there will be on the Fed to reflect that reality in its policy.
“…we believe continued below-target inflation should move the Fed to a policy response.”
Inflation’s Downward Path
For the 12 months through April 2019, this measure shows 1.57% inflation. This is down from a 2.03% rate for the 12 months through September 2018. More interestingly, monthly inflation has been running noticeably lower since mid-2018. In the last nine months since July 2018, the average annualized inflation rate for core PCE is a mere 1.40%.
Exhibit 1: Monthly Gains in Core PCE Price Index
This matters because the Fed has been publicly following a professed 2% target rate for core PCE. Only fleetingly over the last seven years has actual inflation been near that target, let alone sustained it…and recent experience could be pulling actual experience as far below target as we have ever been since the 2% target was first announced.
“Only fleetingly over the last seven years has actual inflation been near that target, let alone sustained it…”
This is especially true given that Fed officials have recently been talking up the idea of targeting 2% average inflation over time, so that if inflation runs below target for some length of time, a commensurately long run of above-target inflation would then be warranted. Indeed, the Fed this month held a conference to discuss whether and how to implement such average inflation targeting (AIT) strategies.
Of course, various Wall Street analysts and some Fed officials themselves firmly believe that the current declines in inflation are transitory, and that inflation will be rising by the end of this year. Fed Chair Jerome Powell himself has remarked to this effect. But what if they are wrong? What if the current run of especially low inflation is sustained? Given the importance of below-target inflation discussed above, it certainly appears that further sustenance of inflation around recent rates would have impact on Fed policy.
This paper attempts to assess the chances that the recent run of 1.5% or so inflation is sustained. We’ll identify the price components that have driven the recent deceleration and analyze whether these look to be merely transitory or, rather, more meaningful. We’ll also discuss price components that may serve to provide upward impetus to inflation rates in coming months. Last, we’ll touch briefly on inflation fundamentals.
In the final analysis, it is a coin flip whether core PCE inflation remains around 1.5% or works somewhat higher. However, we think it is likely that inflation will remain below the 2% target. The recent run of experience may have pulled inflation below sustainable rates…but maybe not. In any case, we believe “sustainable” inflation rates are below 2%, and that in itself could be an issue for Fed decision making.For the 12 months through April 2019, this measure shows 1.57% inflation. This is down from a 2.03% rate for the 12 months through September 2018. More interestingly, monthly inflation has been running noticeably lower since mid-2018. In the last nine months since July 2018, the average annualized inflation rate for core PCE is a mere 1.40%.
Exhibit 2: 9-Month Annualized Core PCE Inflation
Inflation Has Been Declining Since Mid-2018
Exhibit 1 attempts to get around the shortcomings of the 12-month inflation filter by showing both one-month and 12-month annualized inflation rates for the core PCE price index. In the chart, the 12-month inflation rate has been heading down since January 2019. However, the one-month rates, for all their volatility, show a clear tendency to decline starting in June 2018 or perhaps even earlier.
Indeed, the one-month inflation rates did not show any clear tendency to accelerate in 2017 or early 2018, despite the tick up in 12-month inflation rates then. Rather, that 12-month rate began to pick up in March 2018, when the especially low inflation of March 2017 fell out of this filter and when especially high inflation rates in November 2017 and January 2018 occurred.
Were those outsized increases in monthly inflation in November 2017 and January 2018 really a meaningful flare-up of inflation or merely monthly statistical noise? Certainly, consensus and Fed opinion dismissed especially low inflation in March 2017 as noise, but they embraced the November 2017 and January 2018 spikes as proof of their accelerating-inflation calls. In retrospect, both appear to be spurious, yet both affected 12-month inflation rates for a while, before falling out of the price index.
Some deem the recent slowing in inflation be just another “random” blip. However, it has already been sustained longer than any of the short-term ups and downs of 2017, 2018 or earlier. As stated above, inflation rates have been especially low on average over the last nine months (August 2018 through April 2019).
"Some deem the recent slowing in inflation be just another “random” blip. However, it has already been sustained longer than any of the short-term ups and downs of 2017, 2018, or earlier.”
Exhibit 3: 9-Month Core Inflation: Goods vs. Services
Exhibit 4: 9-Month Inflation Rates
Why the Recent Decline In Inflation?
So, which components of services inflation have driven this? The answer is health care and financial services. The charts in Exhibit 4 show the four largest components of services, totaling 56% of the 76% total provided by services. Of these four, housing and “other services” show no recent deceleration to speak of. However, both health care (blue line, left chart) and financial services (green line, right chart) have decelerated substantially in recent months. Both of these sectors also showed decelerating price increases in late 2014 and early 2017, when services inflation last decelerated. The recent decelerations are perhaps more substantive than those seen previously.
“The recent decelerations [in services inflation] are perhaps more substantive than those seen previously.”
Yes, the decline in portfolio management fees had helped reduce financial services inflation to a scant 1.4% annualized rate through March, but the April rebound there erased all below-average performance (blue line). Even upon excluding these fees, remaining financial services inflation has still slowed sharply over the last nine months (yellow line). Similarly, insurance costs have decelerated as well, albeit more recently and more mildly.
“The financial service price data show a broad-based and sustained slowing. There is reason to expect it to continue.”
Exhibit 5: Financial Services Inflation: 9-Month Rates
The PCE Health Care Price Index includes medical spending on behalf of consumers. This is in contrast to the CPI index, which only includes out-of-pocket consumer spending on health care. Including spending on behalf of consumers—primarily by Medicare and Medicaid companies—as well as out-of-pocket outlays gives health care a much larger weight in core PCE than in core CPI. It also brings government policy initiatives into the mix. It is because health care outlays paid by Medicaid have been thought to have held down prices that the ACA is said to have reduced reported health care inflation.
However, again, the timing of accelerations and decelerations in health care inflation would appear to be at odds with an assertion that the ACA has served to reduce health care inflation. Furthermore, while ACA-related changes to government health care expenditures will be completely phased out by the end of this year, those phase-outs have been gradually imposed for some time now, and yet, again, health care inflation has been trending down for the last year. At a minimum, this fact casts doubt on any forecast for a future acceleration relying on regulatory changes alone. Slowing health care inflation could well be sustained.
“Weak demand conditions could well keep manufactured goods prices especially weak, thence goods deflation overall.”
On the other side of the ledger, the recent step-up in trade tensions and tariffs between the US and China could impart upward pressure on trade-goods prices. Even this is not a sure thing. US imports from China have been declining over recent months even before the tariff imposition. It may be that Chinese producers will not perceive sufficient pricing power to pass along increased tariff costs to purchases, especially if rival producers in Korea, Vietnam and other Southeast Asian economies see the US-China discord as an opportunity to increase market share in the US at the expense of Chinese producers. Similarly, US producers negatively impacted by Chinese tariffs may seek to increase sales in the US and reduce domestic prices to do so.
So, the outlook for goods prices is a mixed bag. Something has contributed to a renewed slowing in domestic goods prices in recent months, even with trade friction looming. That something may not quickly dissipate in the reality of tariffs and retaliatory tariffs. Furthermore, the recent decline in US goods inflation has been eclipsed in recent months by a more pronounced slowing in services prices. Regardless of how tariff effects and factory weakness play out, services prices will probably be the more center-stage phenomenon in determining core inflation in months to come.
Weakening energy prices over the past year were likely a contributor to the recent weakness in public transportation costs, reducing core PCE inflation by as much as 0.05%. With oil prices bouncing in early-2019, there is a chance of that negative influence being reversed. Then again, oil prices have headed back lower more recently.
Exhibit 6: 9-Month Inflation Rates: Transportation Services & Energy
Public transportation costs are a possible upward impetus on core inflation in the months to come, but they are unlikely to be a significant effect. Meanwhile, rising public transportation costs are dependent on steadily rising oil prices, which are not a sure thing.
The Fed has believed that interest rates are below “neutral” levels, so that monetary policy is expansive. This belief has nothing to do with the idea that low interest rates stimulate higher consumption and investment spending. That stimulus evaporated many years ago, when the lagged effects from interest rates to spending wore out. (Remember, short-term interest rates hit bottom more than 10 years ago.) Rather, rates are presently believed to be expansive solely because they are deemed to be below equilibrium/sustainable/neutral levels.
“…rates are presently believed to be expansive solely because they are deemed to be below equilibrium/ sustainable/neutral levels.”
Exhibit 7: Growth in Nominal Spending
The typical “evidence” proffered to prove expansive policy is relatively low unemployment rates. However:
- Again, this proffer is directly contradicted by nominal spending rates which refuse to accelerate,
- Wage growth has been steadfastly non-explosive, straining credibility of claims that Fed policy is artificially stimulating labor demand and
- Claims of low unemployment do not sufficiently allow for observed demographic changes.
It is commonly pointed out that current unemployment rates are the lowest since 1969. However, look at the cohort-specific unemployment rates shown in Exhibit 8. Unemployment rates for prime-age male cohorts are still 1-3 percentage points higher than what was observed in 1969.
“The Fed ceased expanding its balance sheet almost five years ago, and yet term yields have shown no upward pressure since.”
Exhibit 8: Unemployment Rates & Labor Force Shares by Age & Sex, 1969 vs. Currently
If cohort-specific unemployment rates matched those of 1969, the overall male unemployment rate would be 2.4%, 1.3 percentage points lower than what we actually see presently. Similarly, the female unemployment is presently 0.4% percentage points lower than what it would be were 1969 age-demographics still in place.
The present labor force is much older than was that of 1969, and women no longer suffer the same labor force stigma they did then. These obvious facts cast into doubt the significance of the fact that unemployment is at 50-year lows. It is perhaps a stretch to implicitly impose 1969 male-cohort unemployment rates on today’s economy. The fact remains, though, that current aggregate unemployment rates are comparable to those of 1969 only because of the vast demographic changes the economy has undergone since then. Meanwhile, the continued placid paces of economic growth and inflation cast doubt on the relevance of current unemployment rates as indicators of “easy money.”
“We believe it is most likely that inflation will remain below the 2% rate the Fed has targeted.”
While it is not a sure thing that core PCE inflation will remain at the 1.4% pace of recent months, these recent rates look a lot less transitory than Fed comments would try to make them. We believe it is most likely that inflation will remain below the 2% rate the Fed has targeted. The longer observed rates stay at or below that range, the more pressure there will be on the Fed to reflect that reality in its policy deliberations. This is especially so given its recent musing about price level (average inflation) targeting.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
The Personal Consumption Expenditures (PCE) Price Index is a measure of price changes in consumer goods and services; the measure includes data pertaining to durables, non-durables and services. This index takes consumers' changing consumption due to prices into account, whereas the Consumer Price Index uses a fixed basket of goods with weightings that do not change over time. Core PCE excludes food & energy prices.
The Consumer Price Index (CPI) measures the average change in U.S. consumer prices over time in a fixed market basket of goods and services determined by the U.S. Bureau of Labor Statistics.
The Affordable Care Act (ACA) is a federal statute signed into law in March 2010 as a part of the Health Care reform agenda of the Obama administration. Signed under the title of The Patient Protection and Affordable Care Act, the law included multiple provisions that would take effect over a matter of years, including the expansion of Medicaid eligibility, the establishment of health insurance exchanges and prohibiting health insurers from denying coverage due to pre-existing conditions.
Medicaid is a health care program that assists low-income families or individuals in paying for doctor visits, hospital stays, long-term medical, custodial care costs and more. Medicaid is a joint program, funded primarily by the federal government and run at the state level, where coverage may vary.
Medicare is the United States federal government health insurance program for Americans who are 65 years of age and older. ... These benefits are intended to cover the costs of healthcare associated with advanced age.
The PCE Health Care Price Index is a subset of the PCE Price Index, reflecting the costs of health care.
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