Although US headline CPI inflation slowed from +1.4% YoY to +1.0% YoY in February 2016, this was mostly due to lower energy prices. To gauge the underlying trend in US inflation, we focus on core CPI which excludes food and energy. This measure of inflation picked up more than expected from +2.2% YoY to +2.3% YoY, which was the fastest rate since May 2012.
Looking at two key components of core CPI:
- services inflation was up from +2.5% YoY to +2.6% YoY, led by primary and owner-equivalent rents, which were up +3.2% YoY; and,
- medical services costs were up 3.9% YoY.
We think the trends in housing and medical costs (which have core CPI weightings of 42.2% and 8.4% respectively) are two important components to watch as they pose the biggest upside risks to core inflation.
The US personal consumption expenditure core price index (PCE core), is the measure of prices that the Federal Reserve (Fed) targets. It is rising at the fastest pace in more than three years. Interestingly, with PCE core inflation currently at 1.7%, it is already a tenth above the Fed’s target for the end of 2016. Core CPI and PCE core both suggest underlying inflationary pressure is building, something that the Fed will find hard to ignore if wage growth picks up further toward 3%.
What are the policy implications? In March, the Fed reduced its profile for the expected path of interest rates. This appears to have been in response to market worries relating to domestic and international growth. However, the more benign policy profile also implies reduced concern about the inflationary implications of the continuing tightening in the labour market.
We believe the Fed is underestimating the risk of inflation. Furthermore, there is little evidence of a second round disinflationary effect from lower oil prices, and indeed, rising oil prices could now push headline inflation higher. While the Fed may feel that current circumstances justify delaying further rate rises, there is a risk that it will have to become more aggressive later in the tightening cycle inflationary pressure continues to build.
Source of figures: Datastream