Our outlook for US growth and inflation prospects has brightened considerably since the start of the year, so we have lifted our targets for both US Treasury yields and TIPS (1)-based breakeven inflation rates. Here, we review some of the factors we see as contributing to the rise in US inflation before discussing the potential monetary policy response from the Federal Reserve (the Fed).
Transitory factors supportive for US Consumer Price Index (CPI) inflation
To begin with there are a number of transitory factors that will be supportive for year-on-year CPI inflation over the next few months (see Exhibit 1 for an overview of the recent changes in CPI).
The collapse in US cell-phone plan prices that occurred in March 2017 as providers switched to infinite data plans will fall out of the 12-month window in April, driving year-on-year core and headline inflation back up. In addition, the US dollar’s recent depreciation and the strength of commodity and energy prices are likely to have some pass-through effects. Indeed, our forecasts indicate that base effects may drive headline year-on-year CPI inflation to 2.8% by July.
Figure 1. Changes in headline US CPI, core CPI and core PCE, 2006 – 2018
Source: BNP Paribas Asset Management as of 02/03/18
Inflationary impact of protectionist measures by the Trump administration
More recently, we have also begun once again to contemplate the inflationary impact of protectionist measures by the Trump administration – a theme that had faded last summer when the administration’s attention was focused on repealing the Affordable Care Act and passing tax reforms. The recent announcement of tariffs on US imports of steel and aluminum, alongside efforts to renegotiate NAFTA (2), once again raise the specter of retaliation, which could push the CPI higher via import prices. In addition, President Trump has also raised the possibility of raising the gasoline tax as a means of funding an ambitious infrastructure project. Any of these could provide the prospect of a one-off increase in the CPI.
Impact of the 2017 US hurricane season
Last year saw a particularly violent hurricane season including Hurricane Harvey (which flooded Houston), Hurricane Irma (which damaged Florida) and Hurricane Maria (which wrecked Puerto Rico). Houston is the fourth largest metropolitan area in the US and there was extensive damage to residential housing. This has pushed up rents.
The hurricanes also damaged significant numbers of cars – in Houston it is estimated that at least 500 000 cars were destroyed (3). This comes in the wake of a period of booming auto sales since the 2008-2009 recession. As well as being boosted by a strengthening economy and falling unemployment, the surge in auto sales was fuelled by cheap fuel prices, easy credit and pent-up demand. The three-year leases on cars purchased during this period largely ran off by late 2016/2017, which created a glut of supply on the second-hand car market. Hurricane Harvey, however, is reckoned to have destroyed more vehicles than any other single event in American history (4). Of the approximately one million cars destroyed by Harvey, half were in the Houston metro area alone. This created an imbalance in the market for second-hand cars with strong demand exceeding supply. The consequence has been higher prices for the last three months.
So is the improvement in core inflation simply due to hurricane effects? Encouragingly, it appears the answer is no. First, household rents are in any case also supported by the strength of the labor market and demographics, and the rate of household formation in recent months appears to have risen again.
Second, a recent paper (5) by the Federal Reserve Bank of San Francisco confirms that when one disaggregates CPI and PCE (6) into ‘cyclical’ and ‘acyclical’ components, one can see that the cyclical CPI components have been behaving as one would have expected, rising in response to tightening market conditions.
Medical care prices on the cusp of turning higher?
‘Obamacare’ put a ceiling on medical prices and created a drag on the trend rate of medical inflation. Costs for medical care were heavily influenced by administered prices under the MediCaid and MediCare programmes. An analysis (7) by the San Francisco Fed indicates that softening medical care inflation resulting from the Affordable Care Act has been responsible for detracting 0.3% a year from PCE inflation over the last five years (see Exhibit 2 below) compared to the preceding trend, mostly via the hospital care category. While CPI only considers out-of-pocket costs rather than fees paid by the MediCare and MedicAid programs, government-administered pricing schedules still have an influence on medical costs captured by CPI. Looking ahead, although rising healthcare costs remain a key concern for the public purse, there is evidence that the federal government has relaxed constraints on reimbursement rates, and that medical care inflation may at least partially recover in 2018.