US: Inflation has slowed noticeably in recent months - NAB

Tony Kelly, Senior Economist at NAB, notes that US inflation has slowed recently even allowing for ‘one-offs’ but, producer price inflation and wages growth do not show similar weakness, and the currency drag is fading.

Key Quotes

“History warns against simply extrapolating recent inflation numbers into the future. However, we have made a downward adjustment to our inflation forecasts, which suggests there is downside risk to our current view of one more Fed rate hike at the end of 2017 and three more in 2018.”

“U.S. inflation has slowed noticeably in recent months. Annual CPI inflation in February was running at 2.8% yoy, but by May it had fallen to 1.9% yoy. Similarly, the Fed’s preferred inflation measure – the personal consumption expenditure (PCE) price index – dropped from 2.1% in February to 1.7% yoy in April.”

“In part this reflects the recent easing in oil prices. As energy costs, and commodity prices more generally, can be very volatile the Federal Reserve (the Fed) places more emphasis on measures of underlying or ‘core’ inflation. The most commonly used measure of core inflation is the CPI (or PCE) ex energy and food. However, even this has slowed noticeably.”

“In summary, the recent weakness in inflation is substantial and not just due to one or two one-off factors. However, producer price and wage growth do not show similar weakness, currency effects are waning and history tells us not to extrapolate recent inflation readings out to the future.”

“While unemployment surprises can offset the impact on monetary policy of inflation surprises for a while, ultimately inflation is likely to be the more important factor. The Fed’s focus is not the unemployment rate itself, but the extent to which it is below (or above) the Fed’s view of its long-run level. However, not only does the Fed not have a fixed view of the long-run level, its view is dependent on what happens to inflation (the long-run level unemployment is the level consistent with stable inflation when there is no output gap). We saw this dynamic at play in the June meeting where the median Fed view on the long-run unemployment rate moved down 0.1ppt.”

“As we are forecasting a slower return to target than the Fed, this suggests that there is downside risk to our current fed funds rate projections. However, the difference in the forecasts is not particularly large (about 0.15ppt) so at this stage we are staying with our call of a rate hike in December 2017, and three rate hikes in 2018. Like the Fed, however, we will be closely watching the inflation data in coming months.”