If you listen to certain market commentators for too long, you might start to think there’s no inflation to be found in the U.S. This message is consistent with recent low headline inflation for the Consumer Price Index (CPI), which has averaged just 0.8% over the past two years and 1.6% since the financial crisis – well under the Federal Reserve’s inflation goal. While inflation may be harder to find given the globalization of goods over the past 20 years, along with recent dollar and commodity shocks, it’s there if you know where to look.
The inflation feedback loop
Many economists and Fed officials would argue that the “Phillips curve,” or the relationship between the amount of slack in the economy and inflation, has flattened further since the 2008 financial crisis. This suggests that inflation is now less responsive to domestic unemployment and more responsive to changes in expectations about future inflation. Indeed, the University of Michigan Inflation Expectation survey shows that longer-term inflation expectations do appear sensitive to recent headline CPI inflation – suggesting that persistently low inflation increases the risk that inflation expectations can become de-anchored to the downside, creating a self-sustaining cycle of declining inflation.
We don’t disagree. However, we note that recent dollar appreciation and commodity price declines have depressed Phillips curves based on headline or core inflation. And as these effects fade, the expected rise in headline CPI inflation from 1.1% currently to above 2% by the end of 2017 should support future inflation expectations (see Figure 1).
Support from services, housing and medical care
Furthermore, we see evidence that inflation in more domestically oriented services sectors is reacting to diminishing slack. Over the past six months, core service inflation – and particularly shelter, which accounts for over 30% of the CPI basket – has accelerated relative to the size of the unemployment gap. Service inflation is currently running at 3.3%, while annualized shelter inflation is averaging closer to 3.4%, and the Phillips curve for these segments appears to be steepening (see Figure 2).
Headline CPI inflation is also getting a boost from accelerating medical service and prescription drug inflation. Medical care is currently running at 5% and contributing about 40 basis points to year-over-year headline CPI inflation. Out-of-pocket premiums for private health insurance have risen as consumers shift to high deductible plans and insurance companies pass on costs associated with federally mandated limits on Medicare and Medicaid premiums. Meanwhile, pharmaceutical companies have raised prescription drug prices in response to exclusivity regulations and the inability of Medicare and Medicaid to negotiate prices.
To sum up, although headline inflation of 1.1% is still very low, recent commodity and foreign exchange market shocks are largely to blame for this sluggishness. These effects won’t last forever. Underlying inflation of more domestically oriented sectors does appear responsive to the tightening of domestic slack, and the acceleration in medical care inflation is also giving headline CPI inflation a boost. If commodity and foreign exchange markets can maintain some stability moving forward, headline CPI inflation looks set to accelerate into the 2%-2.5% range over the next year – and policymakers should be less concerned about de-anchoring inflation expectations.
Tiffany Wilding is a PIMCO economist focusing on the U.S.