The Post-Crisis Inflation Mystery

Inflation probably is the most important, and puzzling, economic factor today.

The Federal Reserve has a dual mandate of maintaining full employment while restraining inflation. With unemployment very low, the Fed’s primary focus is on inflation these days.

The path of inflation, and the Fed’s expectations of that path, will determine how much the Fed tightens monetary policy and raises interest rates.

While inflation is well above its lows since the financial crisis, it is much lower than it would be historically at recent levels of unemployment and economic growth. Also, the rise of inflation has been very gradual. Every time it seems ready to accelerate, inflation stalls for a few months. That is today’s inflation puzzle.

Conflicting forces in the economy cause the inflation puzzle.

Consider first the cyclical, or short-term, inflationary forces. Housing prices continue to rise. Also, prices for the services that fluctuate with the business cycle have steadily increased. These prices are likely to continue rising at a pace similar to or a little faster than wage increases.

Yet, overall inflation has remained tame because of several secular, or long-term, forces.

The prices of physical goods haven’t increased much. There has been a damper on these prices since the 1990s.

One trend that has restrained the prices of goods is Globalization. Increased trade among nations increases price competition. The bigger role that lower wage countries have played in producing goods also holds down price increases.

Technology and automation can further restrain price increases. There have been plenty of reports about increased productivity and how technology is replacing more and more workers. Most of the savings from automation hold down the prices of physical goods, but technology gradually is bringing price pressure to services industries.

In the short-term, the commodity bear market that ended in 2016 and recent weakness in the dollar also have held down U.S. goods inflation. A reversal of those trends would exert only modest upward pressure on inflation.

Another factor holding down headline inflation the last few years has been lower inflation in medical care and education. For many years, prices in these sectors increased faster than headline inflation, but the data show that, for a decade or more now, inflation in these sectors has declined.

While some analysts and a few people at the Fed are very concerned inflation is about to take off, I don’t see signs of that. The balance between the short-term and long-term factors prevents the type of sharp increases in inflation that were common before the financial crisis. Additional factors restraining inflation at this point are that wage increases remain well below the levels they normally would be at during this level of unemployment, and consumers aren’t borrowing to spend the way they did in past cycles.

It took a long time for headline inflation to approach the 2% level, and further increases are likely to be gradual. There is no reason for the Fed to tighten more aggressively than it already plans to. In fact, there are good reasons for the Fed to err on the side of letting inflation rise significantly before tightening. The global economy still is very fragile from the financial crisis, and central banks have limited tools to halt the next economic downturn. If the Fed doesn’t panic, growth could continue for a long time.

Note: Because of travel this week, I’m writing this week’s Journal a day early. The economic data are through Wednesday afternoon, and the Markets data are as of Tuesday’s close.

The Data

The Kansas City Fed Manufacturing Index continued the string of strong regional bank surveys. The index remained at 17, below its peak in October 2017, but still among the highest levels of the recovery and an indicator of strong growth.

However, the Dallas Fed Manufacturing Index finally declined after a strong run from an extremely high 37.2 last month to 21.4 this month. It still is a very strong number, but it indicates that some of the capacity constraints of recent months might be relieved.

Similarly, the Richmond Fed Manufacturing Index declined to 15 from a near-record 28 last month. This decline was more than expected and was broad-based.

Durable Goods Orders finally reflect the strong growth indicated in the business surveys. The headline number was a 3.1% increase in orders, up from a negative 3.5% last month. In addition, core capital goods rose 1.8% for the month and now are up 8.0% over 12 months. That indicates businesses really are starting to invest for expansion.

Consumer Confidence as measured by The Conference Board fell a little to 127.7 from 130.8. This still is a high level of confidence. Confidence in the stock market, however, is down. Only 35.4% of respondents expect stocks to be higher a year from now, compared to 51% in January.

New home sales declined slightly from last month, but that’s because the two previous months’ sales were revised sharply higher. Even so, sales have been choppy over the last 12 months, rising only 0.5%. Prices for new homes are up 9.7% over 12 months.

Pending sales recovered in February, rising 3.1%, but January’s pending sales were revised down to negative 5.0% from negative 4.7%. This should lead to higher existing home sales in the next month or two.

The S&P Corelogic Case-Shiller Home Price Index also shows that home prices continue to rise. They rose 0.8% in the latest month and 6.4% over 12 months. This 12-month rate is a three and one-half year high.

The third estimate of fourth-quarter 2017 gross domestic product (GDP) was 2.9% annualized growth, an increase from the 2.5% second estimate. The initial estimate of first-quarter GDP will be released in late April.

The Markets

The S&P 500 lost 3.82% for the week ended with Tuesday’s close. The Dow Jones Industrial Average declined 3.57%. The Russell 2000 fell 3.54%. The All-Country World Index dropped 3.11%. Emerging market equities lost 3.43%.

Long-term treasuries rose 1.72% for the week. Investment-grade bonds gained 0.51%. Treasury Inflation-Protected Securities (TIPS) returned 0.77%. High-yield bonds fell 0.27%.

The dollar tumbled 1.01%.

Energy-based commodities increased 1.22% for the week. Broader-based commodities returned 0.37%. Gold rose 2.62%.

Bob’s News & Updates

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