US Inflation To Head Higher In 2020

In 2019 market participants have viewed moves in inflation asymmetrically. Phases of decline, although largely noise, they treated as concerning – thinking that perhaps it’s a slide into deflation (an unlikely event historically). By contrast, the recent acceleration has been largely ignored.

Primarily, this divergent perception reflects a skew on the part of FOMC policy makers. They tend to treat downside inflation surprises more seriously than upside surprises in a world where inflation has been slightly below target since it was introduced in 2012 (never mind that it was substantially above the Fed mandate of price stability for about 50 years before that).

Recent Fed statements suggest that the FOMC might well respond to higher inflation by refraining from raising interest rates anew until inflation breaches 2.5%. I think this approach is unduly risky, given the cyclical state of the economy, but it is tenable if the bond market goes along with it. Refraining has the advantage of aligning with the political calendar, since it is unlikely for any inflation acceleration to broach 2.5% until after the election. This leaves the election winner with a potential problem heading into 2021, however.

Inflation is not Unusually Low

Much of the narrative for US inflation in 2019 depends on the notion that it has been unusually low. There is also a widespread perception that inflation has behaved differently from the rate projected by Fed models: given such a low unemployment rate, the inflation rate should surely be higher. But I would caution against such new age thinking.

A quick scan of inflation rates since 1994 does not suggest that the recent trend in inflation has been particularly unusual (Chart 1). As is almost always the case, the core personal consumer expenditure deflator has risen as a slower clip than the core CPI (the gap averages just below 0.5%-point; in September, it was 0.7%-points).

Looking at the last two late-cycle episodes in the post-1994 era, we see a paradox: the late 1990s experienced core inflation that was even lower than it has been in recent quarters. Core inflation was higher during the 2005-6 late-cycle episode, when there was greater slack than either now or in the late 1990s.

Other Measures of Inflation have Picked Up

Other central banks have developed alternative methods of measuring core inflation. Some of these measures have been adapted to the United States by regional Federal Reserve Banks. The Atlanta Fed has developed the ‘sticky’ CPI—a measure of inflation where the components change relatively infrequently (about 2/3 of the CPI and dominated by services). The Cleveland Fed has developed a trimmed-mean measure, which excludes outlier m/m price increases, whatever their source may be. Both measures have accelerated significantly from low readings nine years ago.

Meanwhile, a simple inflation framework used by former Fed Chair Janet Yellen in a 2015 speech has worked well in 2019. This model posits inflation to be driven by its own lagged values, by inflation expectations, by a measure of aggregate slack, and by the relative price of imported goods. This model does a pretty good job of capturing recent swings, including the dip down from a peak in 2018 to a recent trough in 2019 (Chart 2).

What Would it Take to Push Inflation to 2.5%?

I have used the Yellen model to illustrate my (new) projected path for US core PCE deflator inflation over the next two years (Chart 5). This path projects inflation to be 1.8%oya in 19Q4, 2.2%oya in 20Q4, and 2.4%oya in 21Q4. I assume that inflation expectations are anchored at 2% throughout.

I further assume that the unemployment rate drops to 3.3% in 20Q4, before picking up towards 3.75% in 21Q4. Most important of all, I project the relative import term to shift from a drag on inflation of 0.2%-points in 19Q3 to a boost of 0.25%-point in 21H2. This would be consistent with a firming in goods pricing as the global manufacturing recession ends in 2020, followed by some weakening in USD. I assume this to be partly the result of relative US weakness in 2021 and partly the result of a more difficult US political environment.

Bottom-up Measures of Inflation Still Weak

While I believe the Yellen model deserves highlighting as a useful approach to thinking about US inflation, I remain of the view that a bottom-up approach is also important. There are key components of the US CPI (and core PCE deflator) where movements are driven by sectoral, idiosyncratic factors, rather than the top-down macro variables in the Yellen model.

The two most important sub-components are housing (measured through various rent proxies) and medical care inflation (particularly important to the core PCE deflator). Both measures of rent peaked at the turn of 2016-17 and have drifted down, net, since then (Chart 3). A similar development occurred in previous late-cycle episodes, constraining the acceleration in aggregate inflation. Developments in health care inflation are even more extreme (Chart 4). The collapse in drug price inflation from 5.2%oya in 16Q4 to -0.4%oya in 19Q3 has very little to do with underlying economic conditions.

Bottom line: Upside Risks to Inflation in 2020

Top-down models suggest core inflation could head towards 2.5% in 2020. A reacceleration in goods price inflation, stronger global growth, and a lower dollar could contribute towards this. Bottom-up models are less clear-cut. Nevertheless, viewing recent inflation trends as historically unusual is misplaced and inflation is still alive and present.

Phil Suttle is the founder and principal of Suttle Economics.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)