As the U.S. economic recovery moves into its later stages, inflation has emerged at a surprisingly slow and inconsistent rate, befuddling investors who have watched the expansion set the stage for anticipated price and wage growth. Only recently has data emerged indicating that pricing pressures have approached, and in some circumstances exceeded, target levels from monetary policymakers.
Inflation is a focal point of the Fed’s evaluation of economic health when determining future monetary policy. However, the absence of inflation in the recovery has apparently stumped even the Fed, which incorporated a variety of innovative policies and quintupled the size of its balance sheet over the past decade to combat deflationary pressures. Last month, Fed Chair Jerome Powell said the risks to inflation are “roughly balanced,” but added that the Fed is “slightly more worried about low inflation still,” contradicting the Fed’s longstanding view that the U.S. economy is more prone to overheating.
While signs of price and wage pressure have been building, we believe the overall pricing environment may not prove as threatening as many investors fear, despite solid economic growth, proposed tariffs, and the low unemployment rate. Because of this, it’s conceivable that actual Fed policy may prove less onerous than current projections suggest, with potentially positive implications for investors.
MIXED MESSAGES FROM PRICING DATA
A variety of inflation reports in recent months have displayed alarming headline numbers, only to indicate less threatening signals under the surface. A review of this data shows that the risks from the more popular wholesale and consumer measures are likely more balanced when compared with the Fed’s preferred measures, core PCE and indicators of wage inflation.
For example, last week’s July Producer Price Index (PPI) showed that while wholesale prices remained steady at +3.3% year over year, the core measure, which excludes the volatility in pricing of food and energy components, neared a cycle high of +2.7% year over year. Yet further analysis shows that PPI growth benefited from a jump in goods prices (+4.4% year over year) compared with a gain of just 2.6% in prices for services over the same time period. Since services comprise approximately 80% of economic output, we will have to see more pricing pressure from this critical segment of the economy before concern of a sustained pricing threat becomes justified.
Similarly, July’s Consumer Price Index (CPI) headline reading of +2.9% year over year also suggests increased pricing pressures. Further analysis of core CPI also indicates a cycle high (+2.4% year over year), which is slightly above the peak of +2.3% achieved three times (April 2012, February 2016, and August 2016) since 2008. In each of these instances, however, the forces of supply and demand caused core readings to decline below 2.0% over the ensuing 12 months. This begs the question of whether peaks in core measures are self-sustaining, or self-correcting. We’ll continue to monitor this in the months and quarters ahead.
CORE PCE AND WAGES
Another of the main inflation gauges we watch is core PCE, which is the Fed’s preferred inflation measure [Figure 1]. Core PCE rose +1.9% year over year in June, just below the Fed’s target of 2%. We believe it’s important for investors to remember that the Fed’s official mandates are to ensure as full an employment situation as possible and to achieve price stability. Since the latter is assumed to be +2.0% year-over-year inflation growth, we believe the current core PCE reading must be viewed in the context of stable prices, rather than runaway inflation.
Indeed, inflation this cycle has been more muted than in previous experiences, with core PCE growth averaging +1.7% since the Fed’s first rate hike in December 2015. This compares favorably with the 2.2% average reading from the Fed’s last tightening cycle (from June 2004 to June 2006).