Following its recent abrupt change of direction, the Fed must be sweating ahead of each monthly release of inflation data. Consumer prices for January will have them worried, but not panicking.
Fed Chair Powell has essentially abandoned the orthodox idea that monetary policy should be forward-looking (because of the time-lags involved), and has made it reactive to actual inflation data. He also seems to see no link between the unemployment rate and inflation (despite the clear link between the job market and wage growth). This raises serious questions about policy transmission, in terms of how the Fed thinks that interest rate changes affect the outlook for inflation.
This means that inflation-related data now dominates the outlook for Fed policy. The US has two monthly releases – the consumer price index (CPI) and the personal consumption expenditure (PCE) deflator. There are plenty of technical differences between the two, but the most important is that the CPI has a larger weight for housing and a smaller weight for medical expenses.
Both series report “core” inflation that excludes food and energy, as these items tend to be volatile in ways that do not reflect underlying price trends. The CPI tends to run slightly faster – around 0.2% over the past decade, and historically the gap has been wider. The Fed focuses on the PCE deflator, with a 2% target which is symmetrical, so undershooting is as bad as overshooting.
The December release of the PCE deflator has been delayed by the US government shutdown, but the Fed must be concerned to see the January release of the CPI.
Core CPI rose 2.2% year-on-year, which looks comfortable. However, the month-on-month growth has started to pick up, running at a 2.6% annualised rate over the past three months. This is despite lower energy prices (excluded from core inflation), which have knock-on effects on items such as airfares (which are included).
Source: Bloomberg, Bank of Singapore
If we look beyond the deflationary effect of lower oil prices, supply shortages should be pushing inflation higher as the year progresses. Wages are already running at the fastest pace in a decade and are set to keep rising. Firms have unusually strong profitability, so will absorb much of the increased labour costs through lower profit margins (not great in itself), but some is likely to feed through to higher prices.
How the Fed reacts to a mild pick-up in inflation is hard to judge. Having just made such a dramatic about-turn on the basis of little new information, it is presumably going to be very reluctant to reverse course quickly.
At the least, this should mean no rate hike in 1H 2019 and quite possibly for most of the year. We have one move pencilled in for 4Q 2019 on the basis that sustained above-trend growth should eventually send inflation clearly above the Fed’s 2% target and provoke a response. The “patient” Fed has increased the risk that eventually (2020? 2021?) interest rates will need to rise well-beyond neutral levels.
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Three items on the calendar for the next month could drive markets. First, the minutes of the Fed’s January meeting due on 20 February, followed by the (delayed) December PCE deflator on 1 March. Finally, the next Fed policy meeting on 20 March should be really interesting, as members will have to update the “dot plot” showing where they think interest rates are heading – can they really shift from a median of two hikes right down to zero?
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