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Fed Inflation Reassurance - October 3, 2018

Fed Inflation Reassurance

As Core PCE hits 2.0% and near-term risks are roughly balanced, it appears that, to the Fed, inflation is under control. This is bolstered by a spate of recent Fed research and speeches to the same effect. However, time will tell if the lady doth protest too much.

First, both the Cleveland and Richmond Feds have recently put out research exploring the relationship between producer prices and inflation.

In Producers Under Pressure, Richmond Fed’s Jessie Romero points out that in June 2017 to June 2018, transportation costs were up 7.7 percent, many hard commodities were up double digits, and food input prices rose significantly. “Yet in many cases, rising costs for businesses were not reflected in the prices paid by consumers.” Rather, “while the PPI does paint a picture of the costs facing various industries, it isn’t necessarily a good predictor of consumer measures of inflation”. Moreover, the Feds aren’t too worried as “even to the extent the PPI does help predict consumer price changes in the short run, in the long run, the overall level of prices depends on monetary policy.”

In An Assessment of the ISM Manufactring Price Index for Inflation Forecasting, Cleveland Fed’s Mark Bognanni and Tristan Young, investigate whether the ISM’s survey price data can improve inflation forecasts. They conclude that “ISMPI has some predictive content for producer prices; however this property appears not to pass through to predictive content for consumer prices.”

Second, Jerome Powell himself addressed those who are incredulous about outlooks predicting that inflation will remain around 2% while unemployment is 4%. In a speech at the National Association for Business Economics, Powell spent a great deal of time covering the Phillips curve. He assured the room that “the economy looks very good” and as a Central Banker, he believes “that many factors, including better conduct of monetary policy [by central bankers]... have greatly reduced, but not eliminated, the effects that tight labor markets have on inflation.” Taking a page out of the BoJ’s playbook, Powell also cites inflation expectations, saying,

“When people come to expect... policy response, a surprise rise or fall in labor market tightness will naturally have smaller and less persistent effects on inflation.”

Powell sees some risks in the form of misestimation of the natural rate of unemployment and tightness in other parts of the production chain. However, if inflation expectations remained anchored, the outlook remains rosy.

While the Fed appears to be on the side of Alfred E. Neuman, “What, me worry?”, despite the recent pullback in ISM data, the recent readings indicate Core CPI may still have some room to run.