Schroders Quickview: End of the cycle for the US?

Chief Economist Keith Wade looks at today’s US inflation release and notes that despite a negative headline inflation print, there are signs that inflationary pressures are picking up.

22 May 2015

Keith Wade

Keith Wade

Chief Economist & Strategist

US showing signs of inflationary pressures

On the face of it, today’s US Consumer Price Index (CPI) inflation release showed a continuation of current trends with the economy slipping further into deflation as the headline rate (which include volatile items such as food and energy prices) fell to -0.2% in April.

However, dig slightly below the surface and there are signs that inflationary pressures are picking up in the US.

The fall in oil prices is largely responsible for the drop in the headline inflation rate and once this is stripped out we see that prices have accelerated in recent months.

CPI accelerating despite weak activity and strong dollar

Core CPI inflation (which excludes food and energy prices) was up by 0.3% month-on-month in April to 1.8% year-on-year, which is nothing too alarming.

However, over the past three months this critical component has accelerated to a 2.6% annual rate, the highest for four years.

Headline CPI will trend back toward the core rate now that oil prices have stabilised, and clearly inflation of 2.6% would be above the Federal Reserve’s long-term goal of 2%.

Of course, we could see inflation fall back as short-term measures can be volatile and it is possible that oil prices drop once more.

Nonetheless, the pickup in core prices comes against a backdrop of weaker economic growth and a strong US dollar, suggesting that there is some genuine inflationary pressure building in the US.

Normally, weak activity and a strong currency would drive inflation even lower.

Healthcare and housing creating inflation pressure

The main source of upward pressure in the latest report comes from the healthcare and housing components, two areas where prices have gathered pace in recent months.

However, we would point to the sharp rise in unit labour costs (the labour cost involved in producing one unit of output) as the main inflation concern at this point.

These constitute the greatest cost in the economy and accelerated to a 5% annualised rate in the first quarter of the year as productivity growth slumped.

Why has productivity growth slumped?

There is much debate about why US productivity should have slowed, but it is a typical symptom of an economy in the latter stages of its cycle.

As the expansion matures, firms run into capacity constraints and have to add more workers. These new entrants are initially less productive and consequently drag down productivity. This means we see weaker growth and higher inflation, which seems to fit the US today.

Will CPI data impact the Federal Reserve's interest rate decision?

This inflation release is unlikely to cause the Federal Reserve to raise rates next month.

However, it does indicate that we are entering the phase of the cycle where the trade-off between growth and inflation deteriorates and requires action from the authorities. Waiting a little longer would give confirmation on these trends.

In our view, September would seem to be a good time to start the process of raising rates so as to limit the buildup of inflationary pressure as this cycle matures.

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