U.S. Dollar Strength And The Deflation Dilemma by Marie M. Schofield, ColumbiaManagement
- The factors keeping inflation low remain U.S. dollar strength and sluggish global trade, together with the deflationary pulse from weak energy and commodity prices.
- While there is little danger of this developing into true deflation, the strong dollar effect will continue to depress inflation for much longer and this has a stronger influence on core inflation.
- The timing of any upcoming shift in Fed policy will remain uncertain until the outlook on the direction of inflation clears.
Another hit to energy costs (retail gas prices fell 17% in January) was the main reason headline CPI plummeted 0.7% in January, the biggest decline since December 2008. The period in late 2008 (the height of the financial crisis) was the last big deflationary pulse that spread far and wide, tanking every inflation metric across the globe. This time falling oil and commodity prices are sending a similar deflationary pulse, and ultra-low inflation is now quite widespread across most global measures.
Source: Bloomberg, January 2015
Slumping energy prices in January pushed U.S. headline CPI negative (-0.1% YoY), the first negative reading since the financial crisis ended. This measure will likely continue to trend lower near term with the periodic 3-month and 6-month averages at -5.2% and -2.5% respectively (annualized) indicating more downside. Alternatively, core CPI saw a rise of 0.2%, although the gains were not broad and mainly seen in core service prices like owner’s equivalent rent (OER has been a big factor levitating core), recreation and education. But if we exclude the rental component, core CPI is up only 1% YoY. Core goods prices remained broadly weak except for apparel. Almost all other core metrics saw little change or were weaker. On a year-over-year basis core CPI is rising 1.6%, close to last month’s reading. However, the core measure looks likely to decelerate further with both the 3-month and 6-month averages trending below the annual rate, and this again indicates softer readings in the pipeline.
Source: Bureau of Economics, December 2014
The factors keeping inflation low remain U.S. dollar strength and sluggish global trade, together with the deflationary pulse from weak energy and commodity prices. In combination, these are pulling headline inflation negative with some pass-through to core measures. There is little danger of this developing into true deflation, at least here in the U.S., as economic growth looks healthy and labor markets are creating jobs and modest income gains. In addition, lower energy prices have boosted the spending power of consumers, although most are holding onto their new found wealth. Oil prices have steadied recently, but the energy effect will dissipate only slowly and depress headline inflation for a few more months. However, the strong dollar effect will continue to depress inflation for much longer and this has a stronger influence on core inflation. Parsing the recent Fed communications reveals a greater focus on the inflation mandate (where the miss is greater) versus the growth mandate (where trends are satisfactory). While the Fed focuses on the PCE deflator series, trends in the CPI and the deflators bear a strong relationship. With the core PCE deflator at 1.3% and modest downside expected in both measures in the months ahead, the Fed needs to be reasonably confident measures will turn up and head toward the 2% mandate over the medium term. That confidence will certainly be supported when the metrics at least stop falling and stabilize, and any hike in advance of this could undermine market views on the direction of inflation. Global inflation measures give no hint of stability as well. Obviously this leaves the timing of any upcoming initial shift in Fed policy most uncertain until the outlook clears.