Transitory factors continue to dominate inflation trends

For months, the Federal Reserve (Fed) has stated that inflation will rise to the 2 percent target rate as economic fundamentals continue to support their estimates.  With the latest release of personal consumption expenditure and consumer prices, both inflation measures have certainly risen to such levels. PCE inflation has largely risen due to improving consumption figures, and housing and transportation continue to prop up CPI inflation.  However, treasury yields have yet to budge significantly, which begs to question, what is going on?

Personal consumption recovers in March

Consumers started 2018 off on a slow footing, with monthly expenditures declining nearly 20 billion dollars each month in January and February. In March, however, personal consumption expenditure increased $50 billion from the previous month (both goods and services) totaling $12.1 trillion – the first rise of the year.  The leading contributor was in recreational goods and vehicle spending, as well as energy spending in the services sector.  As consumers increased their spending, the PCE inflation rate rose from 1.7 percent in February to 2.0 percent in March, officially hitting the Fed’s target rate.  Even core PCE inflation (which strips food and energy) held constant at 1.5 percent between October 2017 and January 2018, but finally rose to 1.9 percent in March, the highest level in more than a year.  If consumers continue to increase their pace of spending, there may continue to be upward price pressures as we enter the summer.

Exhibit 1. PCE and Core PCE price index, percent change year-on-year.  Source: St. Louis Federal Reserve, FRED Economic Data

Despite the encouraging data, bond yields remain flat

The bond market seemingly shook off the latest releases of PCE inflation data on April 30th, which was puzzling at first glance given how the Fed might react to data moving n their preferred direction.  Throughout the early morning, bond yields hovered around 2.96 percent, and after the release of the spending data, yields fell to 2.95 percent.  They remained anchored around that range throughout the trading day, ending at 2.947.  So, what happened?

Bond yields were underwhelmed by higher inflation numbers

Exhibit 2. Yield on US 10-year Treasury Note, intraday moves. Source: Bloomberg

For one, the economic data was in-line with market expectations, as the figures were close to their estimates. As a result, there was little surprise factor for investors to really move out of fixed income. Second, the bond market has likely already priced-in rising inflation.  In just under 20 days, the 10-year treasury yield rose from 2.777 percent on April 6 to 3.028 percent on April 25 – a move largely attributed to the market believing the Fed will hike rates 4 times this year instead of 3, as both the New York Fed President and Cleveland Fed President prepped the market for such hikes for the rest of 2018.  Lastly, demand for US Treasuries could continue to keep some sort of lid on how high yields go.  Treasuries are backed by the United States government and are considered the safest securities in the world.  As the US is a net debtor, there is seemingly always a suitable buyer of such assets.

Oil price increases are likely to be transitory and wireless services have stabilized, not risen

Another reason that yields may not have moved very much deals with the inflation data itself. Inflation, as measured by the consumer price index, has again risen to high levels last seen in early 2017.  In March, CPI inflation reached 2.4 percent and core CPI inflation reached 2.1 percent, up from 1.7 percent and 1.5 percent, respectively in January.  Housing continued to make up the largest share of inflation, contributing 1.24 percentage points to the total March rate of 2.4 percent.

Over the first three months of the year, the most significant, positive change in consumer prices was in the transportation section of the CPI.  In January, transportation contributed 0.50 percent points to the total inflation rate, and by March it rose by another 0.14 percentage points – the highest of all CPI components.  The price index of motor fuel, a sub-section of transportation, has steadily increased over the past year, rising from 207.3 in January 2017 to 228.1 in March 2018, or approximately 10 percent.  Motor fuel’s contribution to aggregate CPI inflation rose 0.11 percentage points between January and March of 2018.

This isn’t necessarily a surprising development, as oil prices have risen over the past year, with Brent crude hitting nearly $70 per barrel recently.  According to the US Energy Information Administration (EIA), the average price of crude is expected to be around $63 per barrel this summer, $12 higher than last summer.  One of the reasons for the rise is likely due to supply shocks in Iran and Venezuela, where output could take a hit due to sanctions.  In addition, both are OPEC countries and the oil cartel continues to reduce output among its members in order to help stabilize the market and raise prices.  However, when looking at crude oil futures, the price is expected to abate by 2019, which, of course, could bring domestic prices back down.  As a result, the more volatile oil prices are likely to be transitory as we move into the back half of 2018.

The education and communication section of the CPI is the other most-changed component.  However, the reason for this change is much different.  In 2017, wireless carriers were competing heavily for increased market share, which resulted in significant price declines. Many carriers began offering free or heavily discounted data usage costs in addition to providing a number of services for a fixed price.  As a result, this dragged on inflation.

As these competitive price battles have largely subsided, wireless service prices have remained relatively flat. Also, higher prices from the past fall out of the data and a new base-line is used to calculate inflation.  As a result, the drag on consumer prices reduces, which is exactly what has happened in the education and communication section of the CPI.  In January, these components dragged on headline inflation by -0.12 percentage points, but by March the drag was only -0.01 percentage points – an 0.11 percentage point rise in the first three months.  As a result, part of the rise in inflation is simply due to negative transitory affects abating, rather than prices recovering.

Exhibit 3. Components of CPI and their contributions to inflation; YTD change.  Source: Bureau of Labor Statistics.

To put it simply, the market has likely prepped for both the Fed and rising inflation, which is resulting in relatively flat yield movement more recently.  The economic fundamentals continue to showcase a rather strong US economy, but the recent rise in inflation likely due to transitory and base affects, which is not ideal when looking for an upward trend in consumer prices. The data is encouraging, but there are still doubts that higher inflation is here for a prolonged period.

 

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