(Bloomberg View) -- To some, the U.S. economy is on the verge of experiencing a sharp upturn in inflation that will force the Federal Reserve to accelerate the pace of interest-rate increases. The reality is that the balance of risks around inflation has normalized, which should be good news for equity markets that have been on high on alert for the prospect of an aggressive Fed.
Inflation is usually viewed on a trailing 12-month basis, which means that if prices move sharply in a particular month, the shock is carried over for the next 11 months before it drops out. This is relevant because energy prices were declining around this time last year, causing a drag on the inflation data. But now, a simple model that translates the current price of Brent crude oil to an estimate for the headline personal consumption expenditure index suggests that measure of inflation will rise to 2.5 percent by July before retreating. That’s higher than the Fed’s current projections.
Some 60 percent of the run-up in oil prices from the lows can be attributed to low supply rather than high demand. After all, proxies for global demand such as copper prices and bond yields have not moved as much as oil. This is not surprising given escalating tensions in the Middle East. However, it does raise the risk that supply conditions could come into better balance once the tensions subside, sending oil prices lower. As such, the Fed should thus ignore the recent price run-up.
Much of the recent increases in survey and market-based measures of inflation reflect this headline phenomenon. Inflation breakeven rates have returned to their recent highs, which is not surprising given the strong correlation with oil. The 30-day rolling correlation on daily changes between oil and inflation expectations is a robust 0.45. Similarly, regional manufacturing indexes have been in the spotlight lately because of the uptrend in the “prices paid” portions of the surveys. Again, like inflation expectations, this largely appears to be a proxy for energy prices. The contemporaneous correlation with the year-over-year changes with consumer prices related to energy is 0.86.
Meanwhile, core PCE started 2017 running about 1.9 percent, just short of target the Fed’s 2 percent target, before finishing the year at just 1.5 percent. Although the latest data show a welcome pick-up, a breakout is unlikely. To see why, consider a model popularized by former Fed Chair Janet Yellen. In short, core inflation is largely a function of inertia, or previous readings of core inflation and long-term inflation expectations. The model, which also incorporates labor market slack and the relative price of imports, is pointing to an acceleration in core inflation but not to a level that exceeds the Fed’s forecast. Importantly, long-run inflation expectations remain tame.
Finally, much of the recent run-up in core prices appears to be concentrated among a few items. While food and energy prices tend to be volatile, removing these two categories alone can result in some bias. Trimmed-mean measures of inflation, which remove components above or below a certain threshold, thus taking out the most volatile inputs, show that this measure of CPI has run about 0.2 percentage point lower than core CPI over the last year. That suggests the current pick-up in inflation is not especially broad-based.
Admittedly, inflation risks are no longer skewed to the downside, having returned to a more normal environment. That has created some volatility in markets of late, but being closer to normal is largely good news and there is some chance that the recent firming of inflation might lead to some companies posting revenue figures that beat estimates in the current reporting season.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Neil Dutta is the head of economics at Renaissance Macro Research, responsible for analyzing global trends and cross-market investment themes.
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