How meaningful is the pickup in US procyclical inflation

14 Mar 2019

Pro-cyclical inflation has spilled beyond housing into other sectors, including communications. But telecoms’ future contribution to inflation – or disinflation – will depend on the pace and price impact of technology.

With this regime shift coming slowly into view, the best course of action in the meantime is for the Committee to use maximum discretion within its current flexible inflation targeting regime and not react too aggressively should core inflation rise from here. New York Federal Reserve Bank President John Williams has implicitly made the same case, recently commenting that increasing the policy rate at this point, “would require a different outlook for growth or inflation”, and the Committee’s median projection already has core inflation rising to two percent this year.

 

A patient view of inflation

His comment also implies that the median interest rate projection for 2019 will be revised downward at the March meeting to reflect no more than one rate increase. And it is not just Williams calling for patience. It is remarkable how even reliably hawkish Committee members such as George and Mester have backed away from prior assertions that the Committee needs to continue raising rates to guard against an inflation overshoot.

If Williams and other Committee participants are suggesting that inflation around target should not necessitate further rate increases, then the inflation outlook will take on even greater importance for investors in the months ahead. And the recent data has revealed some modest firming in inflation. After incorporating prior months’ revisions, in the fourth quarter of 2018 the monthly core Personal Consumption Expenditures (PCE) price index rose at an annualized rate of 2 percent, compared to 1.4 percent in the third quarter.

 

Inflation: not all increases are the same

Still, not all inflation increases are the same – it is important to examine whether the increase in inflation occurred in cyclically sensitive components (which respond to economic slack), or in a-cyclical categories where price developments tend to be driven by sector-specific factors and hence have little correlation with the economic cycle [2].

As seen in the left-hand chart below, the increase in core inflation has indeed been driven by pro-cyclical inflation. Of note, the increase in pro-cyclical inflation has not been driven by the housing sector. As seen in the right-hand chart, the “other services” category, which includes communications, education, professional, personal care, housing utilities excluding energy, and social services, has evidenced some firming over the past year. Indeed, this price category is now rising at its strongest pace of the expansion. This suggests some broadening out of inflation pressures beyond housing, exactly what one would expect for pro-cyclical inflation at this stage in the recovery.

Exhibit 1a: YoY change in sources of core PCE inflation

core-pce-inflation-ex1

Source: BNP Paribas Asset Management, “Slack and Cyclically Sensitive Inflation“, Stock & Watson, 14 June 2018

Exhibit 1b: Decomposition of pro-cyclical inflation’s contribution to core inflation

procyclical-inflation-proportion-ex2

Source: BNP Paribas Asset Management, “Slack and Cyclically Sensitive Inflation“, Stock & Watson, 14 June 2018

 

A center of inflation: telecommunications

This broadening-out of inflation pressures, however, remains rather modest, and a deeper dive into the data suggests reason for caution. Not only is the firming of pro-cyclical inflation occurring in just one major category, “other services”, but looking within this category reveals that half the 20bp increase in inflation from other services comes from one area – communications.

Recall that this category has experienced quite a bit of price volatility over the past two years as a result of quality adjustments by the Bureau of Economic Analysis (BEA) to cell phone plan pricing. So the pickup in communications prices last year mainly reflects base effects, as the early-2017 quality adjustments rolled out of the year-over-year inflation calculations.

 

Technology: breaking the inflation mold?

A key question going forward is whether the pace of technological changes and their impact on prices is speeding up. If so, we can expect more quality adjustments in more price categories in the years ahead. If this is indeed the case, the apparent weakness in pro-cyclical inflation in 2017 and 2018 might signal a structural break. Alternatively, if the price impact of technology is not becoming more pronounced, we should expect a further pickup in pro-cyclical inflation, given how tight the labor market remains.

Exhibit 2: YoY pro-cyclical inflation and labour market slack, 2002-2018

labour-market-slack-ex3

Source: BNP Paribas Asset Management, “Slack and Cyclically Sensitive Inflation“, Stock & Watson, 14 June 2018

 


Source: BEA, BNP Paribas Asset Management, through December 2018. The unemployment gap is the difference between the U3 unemployment rate and the CBO’s estimate of NAIRU.

Also read: Developments and prospects for US inflation

 

[1] The Federal Reserve’s evolving policy strategy framework

 [2] Our work on pro-cyclical and a-cyclical inflation is informed by the work of Mahedy and Shapiro, as well as Stock and Watson.  The pro-cyclical components of core inflation are all service categories, accounting for roughly 45 percent of core PCE inflation.


Please note that this document may contain technical language.

For this reason, it is not recommended for readers without professional investment experience.