US inflation: is the Phillips curve about to bite back?

Posted on Wednesday, September 20, 2017 at 10:14AM by Registered CommenterSimon Ward | CommentsPost a Comment

The lack of response of US core inflation to a tightening labour market in recent years echoes experience in the first half of the 1960s. Then, core inflation embarked on a sustained rise only after the unemployment rate fell below 4.5% and then 4% in 1965-66. The jobless rate is currently 4.4% and, on the expectation here of solid economic growth in late 2017 / early 2018, may soon reach 4% or lower. The risk of a “non-linear” inflation response to a further unemployment decline may contribute to the Fed raising rates by more than markets expect by spring 2018.
The three-month rate of change of core consumer prices (i.e. excluding food and energy) rebounded to 1.9% annualised in August, equalling its average over 2012-16. This supports the argument in a previous post that weak core data earlier in 2017 reflected pay-back for an overshoot last winter together with a temporary drag from a large drop in the measured price of wireless telephone services. A narrower core measure excluding such services rose at a 2.1% annualised pace in the latest three months – see first chart.

Standing back from recent volatility, however, core inflation has, as yet, shown no response to a large fall in the unemployment rate and wider measures of labour market slack in recent years. The Fed’s preferred core inflation measure, the annual change in the personal consumption expenditures (PCE) price index excluding food and energy, has remained below 2% despite the jobless rate falling from more than 8% to 4.4% since 2012 – second chart.

Recent experience does not, as is sometimes suggested, represent an anomaly by historical standards. Core inflation also remained below 2% over 1961-65 as the unemployment rate fell from over 7% to 4.5%. The core rate rose sharply, however, after the jobless rate moved below 4.5% in late 1965 and 4% in early 1966. Core inflation reached more than 3% by late 1966 and climbed further in 1968-69 as the labour market remained stretched – third chart.

As previously discussed, the forecast here, based on narrow money trends and the status of the Kitchin inventory cycle, is that the economy will grow robustly in late 2017 / early 2018, implying a further erosion of labour market slack. While the unemployment rate has stabilised at 4.3-4.4% since April, the jobs hard to find / jobs plentiful responses in the Conference Board consumer survey suggest that the trend remains down – fourth chart.

Fed officials are aware of the risk that the “Phillips curve” relationship between core inflation and labour market slack will steepen as the labour market continues to tighten. A 2016 Fed working paper found evidence, not confined to the 1960s, for such a non-linear effect, concluding that “it would be unwise to assume the Phillips curve remains so flat at all levels of the unemployment rate”.

According to the paper, there have been two distinct inflation “regimes” since World War Two: a “stationary” regime, characterised by low, stable inflation expectations, covering the 1950s / 1960s and the period from the mid 1990s to the present; and a “non-stationary” regime in the 1970s, 1980s and early 1990s, when inflation expectations became “unanchored” because of shocks and policy mistakes. Separate Phillips curve relationships should be estimated for the two regimes.

Simplifying the analysis in the paper, the following chart shows a scatter plot of core inflation against the unemployment rate, lagged by one year, using annual data from 1955 to the present. There is no correlation across the data set as a whole (red and blue dots) but a Phillips curve can be fitted to the stationary regime data points alone (red dots). This curve is almost flat at unemployment rates above 4.5-5.0% but steepens progressively below this range.

Weak core inflation readings and a stabilisation of the unemployment rate since spring 2017 have caused some Fed officials to doubt the urgency of further policy tightening. With core price trends apparently normalising, a resumption of the fall in the jobless rate in late 2017 would be likely to shift the Fed’s focus back to inflationary risks from labour market overheating, strengthening the consensus in favour of proceeding with regular interest rate rises.

Chinese narrow money trends reassuring

Posted on Friday, September 15, 2017 at 02:54PM by Registered CommenterSimon Ward | CommentsPost a Comment

Chinese narrow money continues to expand at a respectable pace, suggesting broadly stable economic growth and inflation through early 2018.

Six-month growth of the “true M1” measure tracked here fell significantly in late 2016 / early 2017 but has stabilised in recent months at about 6%, or 12% at an annualised rate. This is around the middle of the range in recent years and well above levels reached in 2014 ahead of significant economic weakness – see first chart.

The earlier monetary slowdown has been reflected in a moderation in growth of nominal GDP and nominal industrial output, the latter proxied by multiplying the volume of output by producer prices – first chart. With narrow money growth stable since the spring, nominal output growth is unlikely to fall much further and may recover into early 2018.

Six-month growth of the volume of industrial output fell further in August but this may reflect supply-side influences – adverse weather and anti-pollution restrictions – rather than demand weakness. Consistent with this explanation, six-month producer price inflation ticked up, with a significant jump in prices in August alone – second chart.

The suggestion that nominal economic growth is holding up is supported by earnings trends, with the equity analysts’ revisions ratio moving back into positive territory recently – third chart. The PBoC’s third-quarter surveys of entrepreneurs and bankers, meanwhile, were upbeat, reporting further rises in confidence levels and profitability assessments – fourth chart.

Broad money is lagging narrow money: six-month growth of M2 excluding financial sector deposits, the preferred broad measure here, is near the bottom of its range in recent years, though ticked up in August – fifth chart. The higher level of narrow money growth, however, indicates that broad money weakness is not (yet) negatively affecting spending plans, probably because the improved economic climate has resulted in a decline in the demand to hold precautionary money balances.

UK MPC on course for November rate hike

Posted on Thursday, September 14, 2017 at 03:18PM by Registered CommenterSimon Ward | CommentsPost a Comment

Today’s communications suggest that the UK MPC will hike Bank rate to 0.5% on its next decision date of 2 November barring downside data surprises or market turbulence.

According to the minutes, a majority of members judged that, if the economy remains on the expected path, “some withdrawal of monetary stimulus was likely to be appropriate over the coming months”.

The unreliability of previous forward guidance increases the pressure on the Committee to follow through on this signal at the earliest opportunity.

The hawkish shift has been driven by recent data indicating stronger-than-expected activity and inflationary pressures – see previous post.

Key data inputs to the November decision will be September consumer price inflation and the preliminary estimate of third-quarter GDP growth, scheduled for release on 17 and 25 October respectively. The judgement here is that inflation would need to fall back to 2.7% or below and growth to undershoot the Bank of England staff’s 0.3% projection to head off a hike.

Major national accounts revisions due to be released on 29 September may also play into the MPC’s decision. The Office for National Statistics has already indicated that growth of household income and the level of the saving ratio over 2010-15 were higher than previously reported – see previous post. A similar upgrade to 2016-17 data could allay some MPC members’ concerns about the impact of a rate hike on consumer spending.

UK data arguing for early rate rise

Posted on Tuesday, September 12, 2017 at 02:34PM by Registered CommenterSimon Ward | CommentsPost a Comment

UK consumer price inflation rebounded to 2.9% (2.86% before rounding) in August and is on course to exceed the August Inflation Report projections of 2.68% and 2.75% for the third and fourth quarters respectively. With activity data and surveys indicating that GDP growth is holding up in the third quarter, and the labour market tightening further, the case for reversing the August 2016 Bank rate cut has strengthened.

A post in July argued that a pull-back in CPI inflation from 2.9% in May to 2.6% in June represented temporary relief and that both headline and core rates would reach higher levels later in 2017. While August headline inflation was on a par with May, the core rate – i.e. excluding energy, food, alcohol and tobacco – moved up to 2.7% (2.66% before rounding). Core inflation is the highest since 2011, or 2009 excluding the impact of VAT changes.

The August increase partly reflected a sharp rise in annual clothing inflation, which may partially reverse in September – prices rose relatively strongly in September 2016. The contribution of electricity and gas prices, however, will increase, with British Gas raising its standard electricity tariff by 12.5% on 15 September. A surprise fall in food inflation, meanwhile, may be reversed: CPI food inflation of 2.3% in August is unusually low relative to producer output price inflation for food products of 5.9%. A rise in the maximum undergraduate tuition fee to £9,250 may exert a small upward influence from October.

The expectation here is that headline inflation will average 2.9% over the remainder of 2017, with a 3.0% reading likely in at least one month.

Output and turnover data released last week suggest that July GDP was 0.3% above the second quarter level, i.e. third-quarter growth is on track to match or exceed the 0.3% projection in the August Inflation Report. The single-month unemployment rate fell to 4.2% in June, below the Report's 4.4% forecast for the second half. Staff placements are rising strongly while candidate availability has declined further and starting salaries for permanent jobs are increasing at their fastest rate since 2015, according to the latest Recruitment and Employment Confederation survey.

Cell phone effect cuts US inflation, boosts growth

Posted on Monday, September 4, 2017 at 02:31PM by Registered CommenterSimon Ward | CommentsPost a Comment

A significant portion of the recent fall in US core inflation is attributable to a quality adjustment to cellular phone charges to reflect plans allowing unlimited data usage. This statistical effect should – and probably will – be ignored by the Fed in deciding how fast to “normalise” monetary policy.

The Fed’s preferred core inflation measure – the annual increase in the personal consumption expenditure price index excluding food and energy – fell further to 1.41% in July compared with a recent peak of 1.91% in October 2016. Three-tenths of the reduction over this period is attributable to a much faster rate of decline of cell phone charges. A modified core measure excluding cell phone services fell from 1.98% to 1.63% between October and July – see chart.

Cell phone users aren’t spending any less: aggregate outlays on cell phone services actually grew by 1.1% in the year to July. Official statisticians, however, reckon that consumers are getting much better value for money, mainly reflecting the shift to unlimited data plans, so their estimate of the price per unit of services has fallen by 13.3% over the past 12 months.

By extension, the volume of services consumed, according to the statisticians, has surged by 16.5% over the past year, contributing 0.21 percentage points to overall personal consumption growth of 2.72%.

This statistical procedure may or may not be justified but the negative impact on inflation should be ignored by the Fed, because the shift to unlimited data plans is a unique event and has no relevance for assessing whether monetary conditions are appropriate to achieve the 2% inflation target over the medium term.

Core inflation excluding cell phone services of 1.63% in July is below a 2016 average of 1.80% but up from 1.39% in 2015. The Fed must balance the current undershoot against a rising pressure of demand on available supply capacity, suggesting a future inflation increase. Economic strength in late 2017 / early 2018 is expected here to shift the Fed’s concern towards the latter, even if core inflation remains at its current level.