United States

Inflation creep looms over economic growth, policy decisions


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Headline inflation in the consumer price index (CPI) will jump to 2.3 percent by the end of the year, up from the current reading of 0.2 percent, as the impact of base-year dollar strength and weak energy prices fades from the data. Meanwhile, the policy-sensitive personal consumption expenditures (PCE) core inflation reading, which is what the Federal Reserve closely monitors, will increase to 1.9 from the 1.3 percent reading posted through the end of November. While inflation poses little risk to the economic outlook, a look under the hood at core data shows the risk to operating costs for the middle market.

The slowdown in the long-term potential growth rate of the U.S. economy to 1.5 percent, and wage growth in the range of 2.5 percent, both imply a narrowing of resource utilization and an upside risk to inflation during the next two to three years. If inflation moves more quickly back to the Federal Reserve’s 2 percent target, or perhaps even above it, policymakers could find themselves falling behind the curve in maintaining price stability and be forced to increase rates at a quicker pace than the market is currently expecting.

MIDDLE MARKET INSIGHT: A look under the hood at core inflation data shows rising operating costs may be a risk for the middle market.

Key to this forecast is the movement of inflation expectations this year, which, using the 10-year breakeven as the primary metric, now stand at an index reading of 1.58, up from the 2015 low of 1.3. Should inflation expectations trend higher along with the data, then our forecast should be pretty close to the mark. If inflation expectations remain low, however, then it could exert a gravitational pull lower than actual prices in the economy, thus creating the conditions where the economy will continue to undershoot the Fed’s 2 percent target measure for price stability.

Why inflation remains subdued

The U.S. trade weighted real dollar index increased 16.1 percent during the past two years while the prices of West Texas Intermediate and Brent Crude have fallen 64.3 percent and 68.4 percent, respectively. These declines have been primarily responsible low topline inflation metrics. In 2015, U.S. dollar appreciation reduced the policy sensitive PCE core measure by 0.4 percent alone. On top of that, one-time changes to administered health prices have subtracted another 0.2 percent from that measure. Those, however, are transitory factors.

Why topline inflation will jump in coming months

Meanwhile, energy dynamics inside the different inflation indexes are about to shift as the negative base effects from the collapse in energy prices over the past 18 months fade. During a three-month period from November 2014 to January 2015, the headline CPI dropped by 1.3 percent due to the sharp decline in oil and energy prices. If the topline CPI increases by 0.1 percent from December 2015 to February 2016, the core year-over-year measure should leap to 1.6 percent in January (in the data to be published in February) from the very low reading of 0.2 percent through November 2015. This adjustment in core year-over-year inflation prices is at the heart of our forecast for inflation to rise by 2.3 percent this year.

Core inflation firming

Why resource utilization matters

Inside our model of inflation, resource utilization is the primary variable that drives overall price increases. In an environment where there are only 1.4 unemployed people available for every job that is open, and an unemployment rate that is poised to drop to 4.5 percent by the end of the year, rising unit labor costs are a near certainty.

With the long-run growth rate for the economy at 1.5 percent, even a mild acceleration in wages would result in a jump in unit labor costs, thus leading to higher inflation and margin compression for firms. For small and medium enterprises, which continue to report difficulties in finding qualified individuals to fill work openings and are paying increasingly higher premiums to fill skilled, semi-skilled and public-facing positions, this may make it quite challenging to manage operating costs.

It’s all about the core

During the past several years, medical costs have been falling. But that decline has now come to an end, and both households and firms should anticipate an increase in overall medical costs. Through the midpoint of the fourth quarter of last year, medical costs in the CPI are up 3 percent (2 percent one-year earlier), medical care commodities up 2.6 percent, consumer medical care services up 3.1 percent, and consumer hospital and related services up 4.6 percent. Like the base-year effect on energy prices in the topline inflation reading, once the impact of the one-time drop in prices for Medicaid services fades from the core PCE, overall medical services in that measure should accelerate toward 2 percent, up from the 1.5 percent seen during the past six months.

Rents have also continued to climb and should do so again this year. With rental vacancies at 7.3 percent, this implies that conditions are ripe for an increase in CPI rents to above 4 percent in the near term, with additional upside risk, up from the current level of 3.3 percent.

The combination of rising labor costs, medical costs and rents should drive both the CPI and the PCE core year-over-year indexes higher to about 2 percent, right in line with the central bank’s target, by the end of the year. If so, this may shift expectations about the path of interest rates and overall central bank policy in 2017 when the first order of business for the new U.S. president and Congress will be to take a look at tax and entitlement reform. Higher inflation may complicate matters exponentially.


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