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U.S. inflation… what’s up?

The essential

 

From the CPI data, in particular the HCPI, one would get the sense that inflation has decelerated and stabilised somewhat. Yet, alternative CPI measures stand well above headline CPI and show that inflationary pressures are clearly present in the US economy, as also reflected by the core CPI measure.

 

Flag-UK

 January 2020

Flag-FR

Janvier 2020

 

 

Author

 

 

We expect the US inflation rate to follow a gradual upside path for core PCE.

Based on our analysis, we expect the US inflation rate to follow a gradual upside path for core PCE and to have a humped trajectory for headline CPI, with an annual average of 2.3% for headline CPI and 1.9% for core PCE in 2020. Compared with consensus, we are positioned slightly on the high end of inflation expectations for 2020. Yet, the first part of the year should see inflation lifting higher.

When speaking of inflation measures in the US, there is a wide variety of data that could be monitored, yet the most widely followed is the Consumer Price Index (both headline (HCPI) and core (CCPI)). Core PCE (Personal Consumption Expenditure Core Price index) is also widely considered, being the Federal Reserve preferred inflation gauge. 

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As core measures of inflation are constructed by excluding the most volatile items (in particular food and energy components), they tend to show fewer fluctuations and to react more to domestic price pressures, which tend to build up gradually, while, on the contrary, headline inflation is also affected by commodity prices, dependent on import prices and exchange-rate dynamics. This explains the sometimes diverging trends of the two measures and sheds light on different aspects of the inflation transmission mechanism.

 

Yet, by looking behind the headline numbers, one could get a sense of underlying trends in inflation. True,  from the CPI data, in particular HCPI, one would get the sense that inflation has decelerated and stabilised somewhat. Yet, when netting for “tails” and “outliers”, alternative CPI measures stand well above headline CPI and show that inflationary pressures are clearly present in the US economy, as also reflected by the core CPI measure in Chart 2.

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At this particular juncture, energy price trends represent a moderating factor in headline inflation (headline CPI at 1.8% YoY in October), which remains below the core measure (2.3% YoY), as can be seen in the chart below. 

Picture-3

Inflationary pressures are clearly present in the US economy.

Netting for the energy component and looking at core CPI, both services and goods components support the rise in core price dynamics, currently and likely forthcoming: while core services are near the 3% YoY rate, core goods moved out from deflationary territory and have stopped being a drag on core inflation.

Within the services category, due to the inflation basket composition, shelter has a major role, yet it is fair to note that non-shelter inflation recently moved to a higher trend, too, supported by a sizeable surge in medical care services (representing more than 8% of CPI core index). Yet this is not the only factor lifting core inflation higher.  (Chart 4). Indeed, within core services inflation, the majority of drivers are moving above 2%, as seen in Chart 5.

Picture-4&5

 

Within the goods category, too, there seems to be a common upside trend (Chart 6), although some categories remain in negative territory (such as education and communication) or somewhat volatile (like apparel). Although core goods account for “only” 25% of overall core CPI, developments in this space need close monitoring (as already 75% of Core CPI, i.e. services, is running at 3% YoY). Moreover, risks to imported goods posed by the latest implemented tariffs may have some impact in the future, although they are not yet visible in current dynamics.

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Compared with consensus, we are positioned slightly on the high end of inflation expectations for 2020.

Based on our analysis, we expect the US inflation rate to follow a gradual upside path for core PCE and to have a humped trajectory for headline CPI, with an annual average of 2.3% for headline CPI and 1.9% for core PCE in 2020. Yet, as per the chart below, the first part of the year should see inflation lifting higher, in line with the trends highlighted above.

Compared with consensus, we are positioned slightly on the high end of inflation expectations for 2020 (Bloomberg consensus: 2.1%). After slipping during the summer, the 5y5y inflation swap has moved higher in recent months and at the time of writing stands at 2.45% (Charts 7 and 8).

Picture-7&8

 

While on the headline CPI side there are material risks of upside moves above 2%, albeit not long-lasting, with regards to core PCE it looks like structural forces are at play, anchoring inflation and allowing only a smooth upward path.

In order to extrapolate this information, we follow an approach described in a Federal Reserve of San Francisco paper.

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From the proposed analysis it emerges how the cyclical components of inflation (more correlated to the phase of the economic cycle) are working according to expectations, with an above-average contribution to inflation and a pace of growth at cyclical high levels. Yet, structural factors, which are less reactive to the phase of the cycle, remain subdued and below historical standards (Chart 10a & 10b).

Picture-10 a&b

 

In line with the FRBSF, our findings confirm that the main contributors to this depressed trend have in the past been healthcare and a residual category of services (“other services”). Yet, an updated analysis with most recent data would suggest that healthcare price dynamics have deviated from the downside trend and do not look positioned to retrace soon. If this continues, as seems the case per recent data, that would support the view that the base is building for core PCE to trend higher in a more broad-based way.

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USARDI Annalisa , CFA, Senior Economist
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U.S. inflation… what’s up?
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