INSUBCONTINENT EXCLUSIVE:
By Neil DuttaTo some, the US economy is on the verge of experiencing a sharp upturn in inflation that will force the Federal Reserve to
accelerate the pace of interest-rate increases
The reality is that the balance of risks around inflation has normalised, which should be good news for equity markets that have been on
high on alert for the prospect of an aggressive Fed.
Inflation is usually viewed on a trailing 12-month basis, which means that if prices
move sharply in a particular month, the shock is carried over for the next 11 months before it drops out
This is relevant because energy prices were declining around this time last year, causing a drag on the inflation data
But now, a simple model that translates the current price of Brent crude oil to an estimate for the headline personal consumption
expenditure index suggests that measure of inflation will rise to 2.5 per cent by July before retreating
After all, proxies for global demand such as copper prices and bond yields have not moved as much as oil
This is not surprising given escalating tensions in the Middle East
However, it does raise the risk that supply conditions could come into better balance once the tensions subside, sending oil prices lower
As such, the Fed should thus ignore the recent price run-up.
Much of the recent increases in survey and market-based measures of inflation
reflect this headline phenomenon
Inflation breakeven rates have returned to their recent highs, which is not surprising given the strong correlation with oil
The 30-day rolling correlation on daily changes between oil and inflation expectations is a robust 0.45
Again, like inflation expectations, this largely appears to be a proxy for energy prices
The contemporaneous correlation with the yearover-year changes with consumer prices related to energy is 0.86.
Meanwhile, core PCE started
Although the latest data show a welcome pick-up, a breakout is unlikely
To see why, consider a model popularized by former Fed Chair Janet Yellen
In short, core inflation is largely a function of inertia, or previous readings of core inflation and long-term inflation expectations
The model, which also incorporates labor market slack and the relative price of imports, is pointing to an acceleration in core inflation
Importantly, long-run inflation expectations remain tame.
Finally, much of the recent run-up in core prices appears to be concentrated among
While food and energy prices tend to be volatile, removing these two categories alone can result in some bias
Trimmed-mean measures of inflation, which remove components above or below a certain threshold, thus taking out the most volatile inputs,
show that this measure of CPI has run about 0.2 percentage point lower than core CPI over the last year
That suggests the current pick-up in inflation is not especially broad-based.
Admittedly, inflation risks are no longer skewed to the
downside, having returned to a more normal environment
That has created some volatility in markets of late, but being closer to normal is largely good news and there is some chance that the
recent firming of inflation might lead to some companies posting revenue figures that beat estimates in the current reporting season.
