The U.S. Federal Reserve (Fed) must be pleased these days, with its favorite inflation metric nearly hitting its 2% target in March after six frustrating years of falling short.
Investors have embraced the “inflation is back” theme with gusto, driving the yield on 10-year U.S. Treasury notes above 3% last week off the back of higher inflation expectations.1
But some investors worry that surging inflation late in the economic cycle will prompt the Fed to raise rates more aggressively, killing off the recovery.
Take a deep breath, everyone. The economic recovery isn't in immediate danger of being scuttled by the Fed—there are enough disinflationary pressures to help keep the central bank from increasing rates no more than three—or maybe four—times this year.
The recent buzz about the return of robust U.S. inflation hasn't come out of nowhere. Tight labor markets, fiscal stimulus from tax reform and the recent spending bill, and rising commodity prices all suggest upward price pressures should be building. The employment cost index showed the fastest U.S. wage growth since 2008 in the first three months of this year, and tariffs imposed on goods from the European Union and China could eventually be passed on to consumers as well.
But for all the excitement over accelerating inflation, we should remember that similar personal consumption expenditure (PCE) figures were seen last January—and for much of 2016 before that. We've been here before. The inflation data is also being affected by statistical quirks: Changes in cell phone plan pricing and dollar exchange rates are falling out of the year-on-year comparison, while one-off changes are pushing up healthcare inflation.
Furthermore, some factors suggesting a late-cycle inflation surge may not hold water. Nearly half of the stimulus from the spending bill is earmarked for defense, which doesn't feed into core PCE. Despite the first-quarter rise in employment costs, growth in average hourly earnings has been stuck between 2.3% and 2.7% for years and may remain stubbornly low.2
Back in the 1950s, most U.S. consumption involved goods, but now it's mainly services, particularly low-wage, low-hour sectors such as restaurants and shops. That means new jobs tend to be at the lower end of the pay scale. Demographics are also holding down wages as retiring baby boomers are replaced by younger, cheaper workers. There's a glut of cheap labor globally as well, which counteracts upward pressure on wages in developed markets. Finally, technological innovation and automation continue to contain wage inflation.
Widespread tariffs from a U.S.–China trade war could push up some input costs, but this would only marginally feed through into overall price inflation. Tariffs would also drag on U.S. competitiveness and growth, which would put downward pressure on prices.
Other disinflationary forces are apparent if you look at supply and demand in the American economy. The United States has undergone what should be two significant positive supply-side shocks—the tax bill, as expensing in theory encourages investment, and deregulation—and one negative demand-side shock as the Fed removes monetary accommodation. These developments all put downward pressure on prices.
Finally, inflation is no longer a purely domestic phenomenon in a globalized economy. While the United States had strong figures, Japan and the United Kingdom reported weaker headline inflation in March, and Germany and Italy saw headline inflation decelerate in April. You have to wonder whether the United States can buck the general Western trend, particularly if the dollar continues to strengthen.
There are legitimate reasons to expect inflation in the U.S. to accelerate in the next two years, but the American economy is hardly burning the house down, and overheating. A slow, steady rise should be cause for celebration—it means this economic recovery should still have legs.
1 United States Department of the Treasury, as of 5/2/18.
2 U.S. Bureau of Economic Analysis, as of 5/2/18.
Editor's note: This material originally appeared in the Financial Times on 5/1/18.