Our outlook for US inflation and growth has brightened considerably since the start of 2018, so we have lifted our targets for both US Treasury yields and TIPS-based breakeven inflation rates. Here, we review the factors we see as contributing to the rise in US inflation and we look at the potential monetary policy response from the Federal Reserve (Fed).
Certain transitory factors should be supportive for year-on-year (YoY) consumer price inflation (CPI) over the next few months. The collapse in US cell-phone plan prices in March 2017 as providers switched to infinite data plans will fall out of the 12-month equation this April, driving year-on-year core and headline inflation back up. Also, the US dollar’s recent depreciation and the strength of commodity and energy prices are likely to have some pass-through effects. Indeed, our forecasts indicate that base effects may drive headline inflation to 2.8% YoY by July.
Exhibit 1: Changes in headline US CPI, core CPI and core PCE (personal consumption expenditure), 2006-2018, year-on-year % change
Source : Bloomberg, BNP Paribas Asset Management, as of 31/01/2018
More recently, we have considered the impact on US inflation of protectionist measures by the Trump administration. The recent announcement of steel and aluminum import tariffs, alongside efforts to renegotiate the North American Free Trade Agreement, once again raise the spectre of retaliation. This could push the CPI higher via higher import prices. In addition, President Trump has raised the possibility of increasing the petrol tax as a means of funding an ambitious infrastructure project. Any of these could engender a one-off increase in the CPI.
Last year saw a particularly violent hurricane season, which, among other things, damaged significant numbers of cars. In Houston, Texas, it is estimated that hurricane Harvey destroyed at least 500 000 cars, which created an imbalance in the market for second-hand cars with strong demand exceeding supply. The consequence has been higher prices for the last three months.
So is the improvement in core US inflation simply due to hurricane effects? We don’t believe so.
• First, household rents are in any case also supported by the strength of the labour market and demographics, and the rate of household formation in recent months appears to have risen again.
• Second, a recent paper by the Federal Reserve Bank of San Francisco confirms that when one disaggregates the CPI and the PCE indices into ‘cyclical’ and ‘acyclical’ components, one can see that the cyclical CPI components have been behaving as one would have expected, rising in response to tightening market conditions.
‘Obamacare’ put a ceiling on medical prices and created a drag on the trend rate of medical inflation. Costs for medical care were heavily influenced by administered prices under the MediCaid and MediCare programmes.
An analysis by the San Francisco Fed indicates that softening medical care inflation resulting from the Affordable Care Act has been responsible for detracting 0.3% a year from PCE inflation over the last five years (see Exhibit 2) compared to the preceding trend, mostly via the hospital care category.
Looking ahead, although rising healthcare costs remain a key concern for the public purse, there is evidence that the federal government has relaxed constraints on reimbursement rates, and that medical care inflation may at least partially recover in 2018.
Exhibit 2: Contribution of healthcare services inflation to core PCE
Source: Federal Reserve Bank of San Francisco, “What’s Down with inflation?”, as of 27/11/2017
The rise of 2.9% YoY in average hourly earnings (AHE) in January was the fastest since 2009. AHE is a poor measure of overall compensation trends as it is distorted by compensational considerations (e.g. older, better-paid workers leave the labour force and are replaced by younger, cheaper workers). The fact that many baby boomers are retiring increases this distortion.
The Atlanta Fed Wage Tracker adjusts for this compositional bias by looking at employees who have been in the same job for 12 months. This shows that wages have actually been growing at between 3% and 4%, depending on age group, education and skill level. In our view, we are now starting to see confirmation of this trend – data released on 31 January showed that the employment-cost index (ECI), the Fed’s preferred measure of compensation rates, rose by 2.6% in 2017, the largest annual
increase since 2009.
We expect wage growth to rise in the coming years as the US unemployment rate, currently at 4.1%, continues to fall. For 2018, our economists have revised up their GDP growth projection to 2.9% from 2.5% due to anticipated strength in business investment, consumption and residential investment.
We also anticipate the Trump administration’s fiscal boost having a significant positive impact on GDP growth equivalent to 0.5% in 2018/19. Growth at a pace of 2.75% would be well above our 1.50%-1.75% estimate for underlying potential growth, and therefore should drive the unemployment rate towards 3.5%.
Our view is that spare capacity in the labour market will soon be exhausted and that wages seem set to continue rising, even if not rapidly, although this does not of course automatically mean that consumer prices will accelerate.
With labour compensation data likely to improve in the coming months, we expect the Fed to become increasingly confident that underlying inflation is returning to target.
The two latest CPI releases, for December 2017 and January 2018, revealed a gentle firming of core inflation, with strength in shelter costs, vehicle prices and medical care. In January, CPI was also supported by a bounce in clothing prices after several months of decline.
We expect the Fed to raise interest rates by more than is currently priced in by financial markets. We anticipate four increases in 2018 followed by at least a further three in 2019.
Since the start of 2018, we have revised upwards our forecasts for US nominal yields, largely as a result of the additional fiscal stimulus announced in February, which in our opinion will warrant a more forceful tightening from the Fed, and could cause some indigestion from the additional supply.
We now think 10-year nominal yields could reach 3.25%, (from 2.86% currently). Meanwhile, 5-year 5-year real (TIPS) yields could rise to 1.25% (from 1.04% currently).
On the breakeven (BEI) front, we have revised our target for 10-year BEI from 2.15% to 2.25%, given the additional fiscal impulse to growth, and evidence that underlying inflation is moving higher, both for cyclical reasons, and because of improved prospects for medical inflation as the deflationary impact of the Affordable Care Act wanes.
6 March 2018