US inflation is set to re-accelerate from higher gasoline prices and dollar weakness
The trend in US consumer price index (CPI) inflation has been weaker than expected since the start of 2017, leading to a slide in medium-term inflation expectation. More recently, although US headline CPI picked up from +1.6% to +1.7% YoY in July, core CPI (excluding energy and food) remained dull at +1.7% YoY.
On the cyclical side, the recent weakness in US inflation was driven by a record decline in lodging costs (hotels, etcetera) and the steep fall in wireless phone prices – developments that are likely to prove transitory. However, heavy-weight components such as rents and medical care costs also remained soft relative to the trend from a year ago. Within goods, auto prices contracted for the sixth consecutive month, as both new and used cars prices fell. Our analysis suggests that inflationary pressure from shelter is now waning after the robust growth rate previously, whilst the rising supply of used cars may continue to weigh on auto prices.
In the near-term, we believe the surge in gasoline prices and dollar weakness will force inflation upwards. Up to one-third of oil refinery capacity has been affected by the disruption caused by tropical storm Harvey and gasoline prices have risen to a two-year high (from a pre-Harvey average of US$2.43 per gallon to US$2.64 at the start of September). Based on our estimates (assuming average gasoline prices of about US$2.50 in September and applying CPI weight of 3.2%), the sustained strength in gasoline prices may boost CPI by as much as +0.5% YoY in September.
The dollar’s trade-weighted Index has fallen by more than 7% year-to-date, leaving it near its weakest levels since mid-2015. According to an econometric model used by the Federal Reserve (the Fed), a 10% depreciation in US dollar would boost core personal consumption expenditure (PCE) inflation by +0.3% in the first year following the currency shock. Applying this framework, the recent dollar weakness could lift core PCE inflation by about +0.2% by mid-2018, with additional upside risk from the reflationary impact of a weaker dollar (for example a pick up in net exports and accordingly GDP growth). Whilst the boost to inflation from gasoline prices and dollar weakness may be regarded by the Fed as transitory, the aggregate impact taken together may be enough to reverse some of the decline in expectations for US inflation.
What is less certain is the impact of a tightening labour market on wage costs and, thereby, inflation. Our analysis of the Phillips curve (the relationship between the unemployment rate and inflation) in the US suggests that it remains valid but that the curve may have flattened post-crisis. This means that lower unemployment is still likely to force wages up, but not to the same extent as in previous cycles. So, as the US unemployment rate continues to fall, likely dipping below 4% in 2018, core inflation may move higher but only gradually.
To conclude, US inflation seems to have already bottomed out and we expect modest upwards near-term pressure from gasoline prices and dollar weakness, both of which may lift currently depressed inflation expectations. We think continued modest gains in inflation, coupled with solid economic growth and a robust labour market will be sufficient for the Fed to increase the Fed funds rate again in December (versus market expectation of June 2018). However, there is evidence that US inflation maybe structurally lower due to the weaker relationship between the unemployment rate and inflation, which may eventually limit the degree and pace of monetary tightening.