Deflation? What deflation? While one month does not make a trend, we’ve had a string of strong U.S. inflation data this month. Average hourly earnings surprised to the upside at 2.5% on a year-over-year basis and today’s Consumer Price Index (CPI) report came in much stronger than expectations: Core CPI jumped to 2.2% from 2.1% on a year-over-year basis thanks to January’s whopping 0.3% month-over-month seasonally adjusted increase, and now core CPI (year-over-year) is actually slightly above its 20-year average. Headline CPI too was robust at 1.4% year-over-year.
Let’s start with wages. A functioning Phillips curve, i.e., the relationship between employment and inflation, is an important component of our investment framework. As the economy reaches full employment, job growth should converge toward labor force growth but this will come with an increase in wages. The rising trend in average hourly earnings confirms our view that the U.S. economy is getting closer to full employment and the Phillips curve is functioning (see figure).
Our outlook for core CPI is largely influenced by the services sector, which we believe will continue to advance. Over the past several years, the strength of the housing market has driven core inflation, and we anticipate that its impact will moderate but continue. We see services playing a more prominent role because of significant improvements in the labor market. Consider price changes experienced over the last few years for things like the cable bill, hotels and healthcare. As shown in the CPI figure below, core services ex shelter have started to tick up over the last year and we expect this trend to continue.
The Fed should be pleased that we seem to be making progress toward its inflation target, but is it too soon for a prophetic “mission accomplished?” While core CPI reached 2.2% year-over-year, the five-year forward five-year breakeven inflation rate, which is the Fed’s favorite measure of market-based inflation compensation, is near all-time lows at 1.4%. Even the five-year forward five-year nominal interest rate at 2.1% is running below core CPI.
Many market observers are concerned that while inflation is only barely closing the gap with the target, with the policy rate still so near 0%, the Fed would be unequipped to deal with the inevitable next recession. Even a modest hawkish signal through a stronger U.S. dollar could kill this continuing recovery. The market is telling the Fed to “run it hot” to anchor inflation expectations higher. Otherwise the next recession could be about choosing between quantitative easing and negative interest rates.