Wednesday, April 23, 2014

America’s next problem is inflation

The return of more solid-looking activity data reinforces for me that US economic fundamentals are continuing to improve and that the next problem for the economy is inflation.  That means the next challenge for markets is the inevitable end of the Federal Reserve’s zero interest rate policy – it’s just a question of when.  Right now the best answer to that question is not yet.

There is also an increasing “solidity” to recent inflation outturns.  At the headline inflation level food prices are rising at a solid clip, posting 0.4% m/m increases in both February and March.  That’s on the back of the extreme drought conditions prevailing on the west coast which is impacting on prices for fruit, vegetables and dairy products.

We should be more interested in core inflation.  Prices increases there have looked a little more solid recently too with rising prices for apparel, medical care and airline fares.  But two-thirds of the 0.2% m/m increase in March came from rising shelter costs along with rents and owner occupied rents.  The shelter index is up 2.7% over the past year – its largest annual rate in six years.  We expect the continued improvement in the housing to put a solid floor (the pun was unintentional) under future core inflation outcomes.
While the FOMC has dropped its quantitative guidance with respect to the unemployment rate, we still look to the labour market to provide the clearest and earliest signs of generalised inflationary pressure.  With demand expected to continue to improve in the period ahead hiring will also pick up, as will wage growth.

The conventional wisdom is that the pick-up in the labour market will be gradual and will therefore put only very limited upward pressure on consumer prices given the significant amount of spare capacity in the labour market.  Seems to me the next question is just how much spare capacity is there?  More on that soon.