Another false alarm on US inflation?

There have been a few false alarms about a possible upsurge in inflation in the US in the past few years, even as core inflation on most measures has remained extremely subdued. There is an entrenched belief among some observers that the huge rise in central bank balance sheets must eventually leak into consumer prices, and they have not been deterred by the lack of evidence in their favour so far.

Another such scare has been brewing recently. Core CPI inflation is running at 1.9% on a year ago, even after today’s reassuring data for June. James Bullard, the President of the St Louis Fed, is warning that an upside inflation surprise is feasible in the near future, if indeed it is not already happening. Although Mr Bullard describes himself as the “north pole of inflation hawks”, he has not previously been a doom monger about immediate prospects for inflation, so his views deserve to be taken seriously.

The reason for the latest scare is that several measures of US inflation had been rising markedly before today’s data. As so often in the past, this happened because of temporary spikes in commodity prices, especially oil. But these have usually been reversed before a generalised inflation process has been triggered.

In order to assess whether inflation is or is not a generalised economic process, several core measures have been developed inside the Fed. These are designed to remove spikes in commodity prices and other “flexible” prices, so that more persistent, underlying inflationary pressures can be laid bare. In the latest inflation scare, several of these core measures had shown a marked increase to their highest levels since 2008, which was worrying. But on today’s data, they have fallen back:

Even before today, the leadership of the FOMC has shown no concern at all about rising inflation, and nor had the financial markets. Given the costs of being wrong about this, it is worth asking whether they are being complacent.

It now seems probable that part of the recent jump in core inflation was just a random fluctuation in the data. There have been suggestions that seasonal adjustment may have been awry in the spring.

But the main reason for the lack of concern is that wage pressures in the economy have remained stable, on virtually all the relevant measures. The Fed published the following chart in last week’s Monetary Policy Report to Congress:

Wage inflation is apparently still fixed at around 2 per cent, exactly where it has been ever since the Great Financial Crash in 2008. Productivity growth is volatile from one quarter to the next but, according to Goldman Sachs’ productivity tracker, the underlying growth rate has been running at about 1 per cent per annum in recent years. That means that the underlying growth rate in unit labour costs (labour costs less productivity growth), which is a crucial indicator for the Fed, is running at only about 1 per cent. This is consistent with price inflation at only half the Fed’s 2 per cent objective.

In a major change from their attitude in recent decades, central bankers (even the Bundesbank) have been suggesting that wage inflation is too low, not too high. In the US, wage inflation needs to accelerate to over 3 per cent before the Fed’s leadership would worry that it indicates above-target price inflation for a significant period of time. Although labour market slack is clearly declining as unemployment falls, Fed research published yesterday argued that there remains a large pool of long term unemployed and discouraged workers that can be drawn back into the labour force as the economy expands.

Can price inflation accelerate meaningfully without this being accompanied by a rise in labour cost inflation? It could do so if import prices, or profit margins, provide an inflationary impetus, but neither seems very likely at present. Profit margins are already at very high levels by the standards of past cycles, and global goods prices, excluding commodities, still seem very subdued.

Atlanta Fed President Lockhart said last week that the Fed should wait until it sees “the whites of their eyes” (meaning higher inflation) before raising rates, and Chair Yellen warned about previous “false dawns” in the economy. There is nothing in today’s inflation data to make the doves change their minds. On today’s evidence, there has been yet another false alarm on US inflation.