Watch the lag: thoughts on core CPI (part 2 – an update)
In a blog post about US inflation published last August, we highlighted the following:
“Core inflation is inertial and has historically operated with a fairly long lag to the real economy. For example, while the last recession officially ended in June 2009, core inflation did not reach a bottom until October 2010.
Within our toolkit for forecasting inflation, we have found that some of the best indicators operate using a 12-24 month lag. Keeping this in mind, we find that several of our preferred leading indicators imply that core inflation should continue to move higher. Parsing through regional and national surveys of business conditions, we find that there has been a clear and consistent trend across surveys that delays in shipments are growing, capacity constraints are building, and input costs are rising.”
Now with the benefit of hindsight, we are able to evaluate our analysis and conclusions from last year. As a little over 12 months of time have elapsed, we are able to confirm that in similar fashion to the historical experience, the strong growth that played out in the US in 2017 and 2018 has finally fed through into the highest pace of core CPI inflation since 2008. As of August 2019, core CPI rose 2.4% from the year earlier.
Some of our leading indicators which we highlighted last year and have since updated for today, such as the NFIB small business survey measure of price plans, suggests inflation may experience one last push higher before slowing down. This is not uncommon, as we highlighted in our first piece, inflation is a long – lagging indicator, meaning core CPI can accelerate into a growth slowdown and does not trough until sometime after the economy has re-accelerated.
While history suggests that monetary policy makers should not be surprised by this dichotomy between growth and prices, in real-time the Fed has often appeared uncomfortable with easing interest rate policy to counter slowing economic growth while inflation is still rising. We are facing a similar situation today. Nevertheless, the Fed should not be uncomfortable because the same leading indicators we highlighted last year such as capacity utilization and measures of input costs are now pointing in the opposite direction. Despite the short-term impulse from higher import tariffs on Chinese goods, other factors such as a stronger US dollar, muted commodity prices and slowing employment growth should eventually cause inflation to roll back over.
Low inflation expectations as determined by the TIPS breakeven market would suggest that investors recognize that the recent strength in realized inflation is a false alarm and are prioritizing the slowing growth outlook when determining fair value on inflation expectations. 5yr inflation breakevens currently stand at around 1.4%, noticeably below the realized annualized rate of core CPI over the past five years of 2.1%.
Keeping all this in mind, the Fed should heed the warning signal of low inflation breakevens as just another reason why the recent move higher in core CPI should not derail their objective to ease policy and promote strong employment amidst a slowing global growth backdrop.