There has been quite a bit of discussion lately on rising inflation and interest rates so we thought we would focus this month's feature article on the inflation watch.
The Federal Open Market Committee's (FOMC or the Federal Reserve) met most recently on January 30 - 31, 2018. The Fed press release issued afterward signaled growing confidence in the U.S. economy and reaffirmed their plans to continue to gradually raise interest rates with an 0.25% increase as soon as their next meeting in March. According to the meeting minutes, several Fed officials believed the economy was positioned to grow faster than their growth projections that were raised at the Fed's December meeting. The stronger potential economic growth confirmed the Fed's plans to raise interest rates three times in 2018 and introduced the potential for a fourth gradual rate hike into the policy discussions if incoming economic data remains robust.
The Fed official statement reads: "The Committee expects that, with further gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market conditions will remain strong. Inflation on a 12-month basis is expected to move up this year and to stabilize around the Committee’s 2 percent objective over the medium term. Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely. (emphasis added)"
The FOMC's Statement on Longer-Run Goals and Monetary Policy Strategy affirmed at their last meeting on January 30, 2018 further delineated the Fed's inflation and interest policy goals as follows:
"The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate. The Committee would be concerned if inflation were running persistently above or below this objective. Communicating this symmetric inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee’s ability to promote maxi- mum employment in the face of significant economic disturbances.(emphasis added)"
Federal Reserve policymakers evaluate changes in inflation by monitoring several different price indexes. A price index measures changes in the price of a group of goods and services. The Fed considers several price indexes because different indexes track different products and services, and because indexes are calculated differently. As highlighted above in the Fed's longer run policy statement, the Fed's preferred inflation measure is the price inflation measure for personal consumption expenditures (PCE), produced by the Department of Commerce. The PCE index covers a wide range of household spending. The Fed also closely tracks other inflation measures, including the consumer price indexes (CPI) and producer price indexes (PPI) issued by the Department of Labor.
Let's take a look at the most recent reports for each of these inflation measures.
The Trimmed Mean PCE inflation rate is an alternative measure of core inflation in the price index for personal consumption expenditures (PCE). It is calculated by staff at the Dallas Fed, using data from the Bureau of Economic Analysis (BEA). (A trimmed mean is a method of averaging that removes a small designated percentage of the largest and smallest values before calculating the mean. After removing the specified observations, the trimmed mean is found using a standard arithmetic averaging formula.)
The Trimmed Mean PCE inflation rate for December was an annualized 1.8 percent. According to the BEA, the overall PCE inflation rate for December was 1.3 percent, annualized, while the inflation rate for PCE excluding food and energy was 2.1 percent. The annualized six month Trimmed Mean PCE inflation rate for December was also 1.8 percent. The overall PCE inflation rate for the last six months was 2.4 percent, annualized, while the inflation rate for PCE excluding food and energy was 1.7 percent. The Fed historically likes to exclude volatile food and energy costs when looking at inflation trends as if you don't need to eat or commute.
The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.5 percent in January, 2018 on a seasonally adjusted basis as reported by the U.S. Bureau of Labor Statistics. As depicted in the chart above, the all items index rose 2.1 percent over the last twelve months before seasonal adjustment, the same increase as for the twelve months ended December, 2017. The index for all items less food and energy rose 1.8 percent over the last twelve months, while the energy index increased 5.5 percent and the food index advanced 1.7 percent.
According to the U.S. Bureau of Labor Statistics (chart above), the Producer Price Index for final demand increased 0.4 percent in January, 2018, seasonally adjusted. On an unadjusted basis, the final demand index rose 2.7 percent for the twelve months ended in January.
The index for final demand less foods, energy, and trade services rose 0.4 percent in January, the largest advance since increasing 0.5 percent in April 2017. For the twelve months ended in January, prices for final demand less foods, energy, and trade services moved up 2.5 percent, the largest rise since 12-month percent change data were available in August 2014. The PPI series may be an early indication of inflation building up in the system if producers are forced to pass on price increases to end consumers.
In addition to backward looking measures of inflation like PCE, CPI and PPI, the Fed also looks at inflation expectations under the premise laid out by Former Fed Chairman Ben Bernanke in a 2007 speech entitled "Inflation Expectations and Inflation Forecasting" that "the state of inflation expectations greatly influences actual inflation and thus the central bank's ability to achieve price stability."
As depicted in the chart below from the St Louis Fed, market expectations have risen in concert with economic growth trends and traditional inflation measures. The chart presents the expected 10 year inflation rate as measured by the difference between like duration Treasury Inflation Protection Securities and regular way U.S. Treasuries. The breakeven rate increased to 2.1% in January, 2018 after falling to 1.2% in February, 2016.
According to the University of Michigan's latest sentiment survey in December, 2017, consumers expect a 2.7% rise in inflation over the next year. The chart below from the St Louis Fed provides a historical perspective on consumer inflation expectations since the rampant inflation of the 1980s. Moreover, year-ahead inflation expectations have also risen among businesses surveyed by the Federal Reserve of Atlanta to 2% in February, 2018 after remaining below that Fed targeted level previously. Both consumers and businesses are beginning to anchor their inflation expectations at higher plateaus.
The foregoing data points suggest that inflation is trending closer and closer to the Fed statutory mandate of 2% with some potential to accelerate through that target given synchronized global growth, dollar weakness, and rising Federal budget deficits and funding requirements of the Trump administration's tax reform, infrastructure, defense and other government spending initiatives.
On February 27, 2018, the new Fed Chairman Jerome Powell gave his first official statements as Fed Chairman before Congress. He testified that the strong economic outlook will prompt the Fed to review its rate-hike path. As reported by Bloomberg, Powell stated, “My personal outlook for the economy has strengthened since December.” “We’ve seen continuing strength in the labor market,” Powell told the House Financial Services Committee. “We’ve seen some data that will in my case add some confidence to my view that inflation is moving up to target. We’ve also seen continued strength around the globe, and we’ve seen fiscal policy become more stimulative.”
Post-testimony markets equity and bond prices fell as markets repriced the odds of a fourth Fed rate hike in 2018 to 50%. These developments may provide additional feedback to consumers and businesses that it is anchors away for former inflation expectations and create a feedback loop for higher inflation trends.