FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
January 9, 2018
1. The Main Ways That We Measure Price Inflation
2. Core-CPI Has Been Below 2% For the Last 8 Years
3. Reasons Why Inflation Could Move Higher in 2018
4. Is 2018 the Year That US Inflation Takes Off?
5. What the US Dollar & Gold Are Signaling for Inflation
As you know, a lot of predictions are made this time of year – about the economy, the markets, interest rates, inflation, etc. Some forecasters are predicting that 2018 will finally be the year when inflation takes off and returns to higher levels. However, some of these same prognosticators have been saying the same thing for the last several years.
The fact is that the US rate of inflation, as measured by the Consumer Price Index, has been declining over the last 25 years. Most prices are moving higher, just not as fast. So, what’s to make us believe we’ll see a big jump in inflation in 2018? I’ll give you the arguments for and against as we go along today.
The Main Ways That We Measure Price Inflation
The most common measure of US inflation is the Consumer Price Index or CPI, which is prepared by the US Bureau of Labor Statistics (Labor Department) and reported monthly. Another popular inflation gauge is the Personal Consumption Expenditures Index or PCE, which is prepared by the US Bureau of Economic Analysis (Commerce Department) and happens to be the Fed’s favorite measure of inflation.
Both Indexes measure changes in the price level of a basket of goods and services commonly purchased by households. The goods and services in the two baskets differ somewhat, as do their weightings of the various items measured.
Within both Indexes, there are various sub-indexes. The most widely-followed sub-indexes are the Core-CPI and Core-PCE. The term “core” simply means that items related to food and energy have been removed because they tend to be highly volatile. The Fed uses Core-PCE as its primary inflation indicator. Most economists I read use the Core-CPI sub-index.
Core-CPI Has Been Below 2% For the Last 8 Years
With that brief introduction out of the way, we can return to our main question for today, which is whether inflation is poised to move significantly higher this year. As you can see in the chart above, core-CPI has been trending lower since the early 1990s and has not been above 3% in over two decades.
Let’s look at the latest inflation numbers which are for November. The broad CPI (including food and energy) rose 2.2% for the 12 months ended November. Core-CPI rose 1.7% over the same 12 months. The broad PCE rose 1.8% for the 12 months ended November, while the core-PCE rose 1.5%.
And here’s perhaps the most interesting statistic I ran across in preparing this article. Core-CPI has risen at an average rate of just 1.76% since 2009. That’s eight years of sub-2% growth in consumer prices (excluding food and energy) on average. The question is, why have price increases been so modest since we came out of the recession?
A confluence of factors has weighed on prices since the Great Recession. For one, businesses coming out of a long period of economic uncertainty and global instability were slow to spend capital, and higher capital spending contributes to inflation.
Meanwhile, banks didn’t lend all the money that the Fed pumped in because they needed to shore-up their balance sheets to account for bad loans and adhere to new stricter regulations. Robust bank lending also contributes to inflation.
Another reason prices of goods haven’t risen as much is because the post-recession period coincided with an aggressive shift to Internet commerce, which resulted in intense price comparison on the part of consumers. The result: conventional retailers could not raise prices as much.
The labor markets have changed, too, with workers less able to demand the higher wages that historically have contributed to higher inflation. Unions are weak and borders are porous, allowing businesses to shift production to lower-cost countries or employ illegal aliens rather than raise employee pay.
Other macro factors have kept prices low. Oil crashed in 2014, thus reducing prices of other energy-related goods. A strong dollar has likewise constrained inflation by making imports cheaper.
The question is, will these price-restraining factors weaken or go away in 2018?
Reasons Why Inflation Could Move Higher in 2018
As usual, there are arguments on both sides of the inflation debate. Those in the “higher” camp point to the strong economy over the last three quarters, and some believe 2018 could be even stronger. A strong economy historically has meant higher inflation.
They also point to rising wages in 2018. Officially, wages grew at the rate of 2.5% for the 12 months ended November. However, more recent data suggest that wages are now rising faster, especially in large cities with low unemployment.
In Minneapolis, for example, private sector workers saw a wage increase of 4% on average in the 12 months ended November, the best increase in six years. Similar changes are occurring in Austin, Denver, Ft. Myers and other large cities where the job market is tight.
Restaurants have been increasing prices over the past year or so to deal with new city and state minimum-wage laws and higher food prices. Apple clearly feels comfortable charging higher prices, as evidenced by its $1,000 iPhone X. And Netflix recently raised its monthly streaming fee for the first time in two years.
And let’s not forget that unfilled job openings remain at a record high above six million. Many companies will have to pay up to fill those positions if the economy remains strong. And then there’s the latest growing trend, just since the passage of tax reform, of large companies giving raises and/or bonuses to their employees.
These are just some of the reasons inflation could move higher in 2018. Which gets us back to the question…
Is 2018 the Year That US Inflation Takes Off?
The arguments for and against higher inflation both have merit. It really all comes down to the economy. If GDP growth stays firmly above 3% this year, and I think there’s a good chance it will, then I would expect that broad CPI (2.2%) will rise somewhat, but not much above 2.5%.
Most economists, however, disagree. A survey of 52 leading economists last month by Blue Chip Economic Indicators found the average expectation was for CPI to stay about where it is at 2.1% for all of 2018. Thus, mainstream forecasters don’t buy the argument that inflation will move significantly higher this year.
The Fed sees core-PCE inflation of 1.9% in 2018, versus 1.5% in the 12 months ended November. If it looks like core-PCE is going higher than that, the Fed could respond with more than three rate hikes this year. In fact, there is increasing talk that the Fed may be considering four rate hikes this year – I’ll keep an eye on that and report as we know more.
What the US Dollar & Gold Are Signaling for Inflation
To round-out our discussion on whether we will see a jump in inflation this year, let’s take a quick look at the trends in the dollar and gold. Earlier, I noted that a strong dollar makes imports cheaper, which helps keep a lid on inflation. As we can see below, the US dollar was rising from 2011 to early 2017.
Since then, the dollar has been declining. Those in the higher inflation camp point to this as another reason inflation is set to turn significantly higher this year. In my view, it’s too early to tell if this is the start of a major downtrend in the dollar.
And to the contrary, if the Fed is going to raise short-term rates three or four times this year, that will generate a lot of foreign demand for US investments and thus the dollar. As a result, I wouldn’t count on a continued downtrend in the greenback.
So, how about gold? Historically, gold has been a good barometer of inflation. Yet gold has declined significantly over the last five years. Those in the higher inflation camp seem to believe that gold bottomed in 2016 and now is in a new bull market.
As I look at this chart, I say it’s way too early to conclude that gold is in a new bull market. And unlike the dollar, higher US interest rates will likely be negative for gold prices this year.
In conclusion, if the US economy remains strong, then I would expect somewhat higher inflation this year, with CPI possibly approaching 2.5% at best. However, with the Fed intent on raising short-term rates three – and maybe four – times this year, I think that will be a headwind to the economy and inflation as well.
Wishing you a profitable New Year,
Gary D. Halbert