There are two important measures of inflation in the US. The Consumer Price Index (CPI) is the more familiar to us over on this side of the Atlantic. On this measure, the most recent reading compiled by the Bureau of Labour Statistics suggests that inflation is rising at 1.7% compared with the same time last year. Meanwhile, core-inflation increased 2.4% over the same period.
But it is inflation as measured by the Personal Consumption Expenditure (PCE) index that is the more important; that is the one the Federal Reserve reference with regard to the 2.0% target. The most recent PCE report, published last week by the Bureau of Economic Analysis, insists that year-on-year inflation is running at the cooler rate of just 1.4%. At the same time, Core-PCE increased 1.8%.
There is a big difference between the two. No so much in absolute terms, but certainly in terms of policy. The Federal Open Market Committee has, for some time, expressed a concern that inflation has been running at a pace well below the target. Indeed, PCE has average 1.4% over the last seven years or so and it is one of the reasons the Fed has cited in cutting rates of late. But while PCE remains muted, inflation has trended higher on the CPI measure – so much so that the most recent increase in CPI marked the sharpest shift in more than a decade.
Ordinarily, we ignore the CPI release and focus more readily on PCE. But we don’t feel comfortable doing that today. Other measures of inflation that don’t share the celebrity attached to the CPI and PCE measures are singing a song not dissimilar to CPI and we are beginning to worry that PCE may be understating inflation a little or that accelerated increases in CPI inflation is a precursor for the same in PCE.
Economists polled by the Wall St Journal expect CPI to trend from 1.7% in the most recent reading (which accounts for the year to the end of August) to 2.0% come the end of December. If the PCE measure does join that particular choir soon, the Fed will have one
fewer reason to dial down rates. As it stands, we expect another 25 basis point cut in 2019, and most likely during the December rather
than the October meeting. In that sense, our expectations are in harmony with the broader consensus. It seems to us that market participants are confident that the Fed will loosen policy further in a bid to support the current expansion and mitigate downside risks from the trade war.
But if the US economy grows at a moderate pace for a while longer, unemployment remains at or close to a 50-year low and inflation does creep back toward target, how easy will it be for the Fed to maintain lower and lower rates?
The answer to that is ‘not easy at all’. All things being equal, and given a prolonged period of inflation-undershoot, we think the Fed could reasonably defend a relatively passive role in the light of a limited overshoot (say up to 2.2%) but only then for a short period of time.
What seems increasingly apparent today though, is that for first time in a long time it is not automatically clear in which direction, and to what extent, US inflation is headed.
What is more certain however, is that both the equity and bond markets are very sensitive to that outlook.