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Economic Research: What's Next On The Path For U.S. Inflation And Monetary Policy?

Economic Research: What's Next On The Path For U.S. Inflation And Monetary Policy?

(Editor's Note: This report was written before the June PCE inflation data was released on July 29. The latest data point doesn't change the overall view.)

Overall consumer price inflation and inflation for items other than food and energy (core inflation) has been weakening since a year ago, following an appreciable rise in the prior 12 months. Consumer price inflation, as measured by the 12-month change in the price index for personal consumption expenditures (PCE)(1), declined from 2.4% in the middle of last year to a rate of 1.5% in May and June (see chart 1). Core inflation, which historically has been a better indicator of where inflation will be in the future, was 1.5% in May and 1.6% in June--down from a rate of 2.0% a year ago.

In light of the reversal of inflation momentum (together with increased downside risks to the growth outlook from global trade and investments), the U.S. monetary authorities moved their policy rate stance from a gradually hiking bias to neutral bias and then, not long after, to an "insurance cut" bias in a short span of time. So, what slowed down U.S. core inflation even as the economy grew at an above longer-run potential growth pace and despite continued solid labor market conditions? Where is it likely headed in the coming months? And what does it mean for the Fed's monetary policy stance?

Chart 1


The Recent Decline In Inflation Was Transitory, And Inflation May Have Bottomed Out For Now

The slowing in core inflation in 2019 reflects particularly low readings in the first three months of the year that appear due to idiosyncratic price declines in a number of specific items such as apparel, used cars, banking services, and portfolio management services. Indeed, in the three months of the second quarter, core PCE inflation accelerated to a 2.5% (annualized) monthly average gains--momentum appreciably faster than 0.7% during the first three months of the year.

The recent increase in inflation momentum is consistent with another well-known price index--the CPI inflation released by the Bureau of Labor Statistics (BLS) two weeks earlier(2). The June CPI showed price reversal on those temporary factors that led to the decline in U.S. inflation in the early months of 2019(3). If the second-quarter monthly pace were to continue (admittedly a crude approach), we could see core PCE inflation reach approximately 1.9% year over year by year-end.

This would be consistent with what the trimmed mean PCE price inflation is indicating(4). The trimmed mean PCE price index (which filters out more noise than the usual excluding-food-and-energy inflation by removing the most extreme price changes in consumer goods and services in either direction), increased 2% in 12 months up to May--hardly suggesting an inflation slow-down away from 2% in the coming months. The five-year, five-year forward inflation expectation rate (a widely used measure of the financial market's inflation expectation) currently stands at 2%, still below 2.2% around the same time last year but moving up since bottoming out at 1.77% in the middle of June.(An aside: there are various measures of medium- to long-term inflation expectations backed out of financial market pricing. Although differences exist on level terms, they all point to an increasing trend since mid-June, a reversal from first half of the year.)

The Shortfall Relative To The Fed's 2% Target Is Not New

To be sure, while much ink has been spilt over recent weakness in inflation, there is no getting around the fact that inflation has struggled to reach the Fed's target for the vast majority of the current expansion. In the 10 years since the recession, both headline and core PCE inflation have increased at an average annualized rate of 1.6%, compared to the Federal Open Market Committee's (FOMC) 2.0% goal, in part owing to the gradual pace of the subsequent economic recovery. The same story is true when you extend the time horizon to 25 years--monthly core PCE inflation has averaged 1.7% in 1994-2019.

Moreover, core inflation in the U.S. has remained within a remarkably tight range of 0.9%-2.6% during the past 25 years. The band of less than 2 percentage points (ppts) is striking, especially considering the list of political and economic events that have occurred during that time(5). This consistency in the inflation trend--also referred to as anchored inflation--is different from pre-1990, when this trend seemed to drift over time, influenced by actual past inflation or other economic conditions.

The Macro Determinants Of Inflation Dynamics

Keeping in mind the role of anchored inflation expectations, our preferred simple reduced-form specification of headline inflation employs (i) an identity of headline inflation, together with (ii) a variant of an "inflation expectations augmented" Phillips curve that includes a global input price shock variable. The specification is similar to former Fed Chairman Janet Yellen's model that she presented in her 2015 speech "Inflation Dynamics and Monetary Policy." This model formally estimates how each component of the expectations-augmented Phillips curve--expectations (of households), persistence (of past inflation), slack (unemployment gap), and global input shock (reflected in relative input prices of non-petroleum imports)--contributes to core inflation, and how those contributions changed during the current expansion since the Great Recession.

This simple two-equation model (see Appendix) fits relatively well with actual headline inflation, although not perfectly (see chart 2). We estimated the equation on a restricted sample ending in 2010 as well; this imparts only a marginal difference--so it's not that something has changed substantially over the last nine and a half years.

Chart 2


That said, we find that the sensitivity of slack has diminished in explaining core inflation dynamics from an already small role (the sign is negative, meaning more slack means lower inflation)(6). Once the leader in determining future price inflation levels, as less (more) slack in the economy usually meant higher (lower) labor cost or wages and subsequently prices down the road, the now flatter wage-unemployment Phillips Curve also means the link of unemployment to wage, and subsequently, to price pass-through is now small.

Chart 3


Chart 4


Since the recession, the estimates of the persistence term and import price have also declined, while the estimates of the expectations channel have increased. Less persistence means that a perturbation to inflation today feeds into tomorrow's inflation to a lesser degree. The increase in the estimate of the expectations term means that consumers are likely to dismiss such perturbations as transitory.

So, where is inflation headed according to macro determinants? Using the sensitivity estimates from our above-specified model, we find core inflation reaching 1.8% by the end of 2019. This assumes the unemployment rate declines further (as in our latest forecast) to 3.4% by year's end, and household inflation expectations stay constant at the most recent level. We forecast non-petroleum import price inflation to become positive beyond the third quarter. Broadly in line with the literature, growth of non-oil import prices(7) is taken as a function of current and lagged values of itself, trade-weighted nominal effective exchange rate, and the foreign trade-weighted producer price index (PPI)(8). (See Appendix for our final model that best describes the data.)

A Bottom's Up Perspective Using Acyclical And Procyclical Decomposition Of Spending Categories

To get a sense of risk around our macro-determinants-based prediction of 1.8% core inflation for the end of 2019, we find it useful to apply a bottom's up approach by breaking down the core PCE inflation into two distinct component series: procyclical and acyclical (see chart 5). Procyclical means inflation historically moves in tandem with the economic cycle, and acyclical means inflation historically moves independent of the economic cycle and is sensitive to industry-specific factors(9). The decomposition into such components sheds light on whether it was cyclical or noncyclical factors that led inflation to climb to 2% in the first place, and what caused the deceleration thereafter, within the span of last 24 months.

Chart 5


As such, we follow Mahedy and Shapiro's (M-S) decomposition in their 2017 paper "What's down with inflation?" that uses Phillips Curve-like models showing that 58% of all core personal expenditure categories (PCEs) were acyclical. The acyclical categories included health care services, financial services, clothing, and transportation. The remaining 42% of PCEs were procyclical, including housing, food services, recreational services, and some nondurable goods.

In the past two years, during which core inflation swung from as low as 1.4% (August 2017) to 2% (July 2018) and back down to 1.5% (May 2019), the procyclical component held steady--averaging 2.4%, which is just about the previous expansion average. Instead, it was the acyclical category that largely drove the swing in inflation momentum--in particular the non-health-care portion of acyclical contribution (see chart 6). Of the 0.4-ppt decline in core inflation since July last year, the non-health-care portion of acyclical sectors subtracted about 0.3 ppt and health care reduced another 0.1 ppt. (See Appendix for further breakdowns of each of the components.) All the while, contribution from procyclical categories held steady at 1.0 ppt.

Chart 6


Has The Risk To Inflation Now Tilted To The Upside?

The decomposition highlights upside risks to the inflation outlook.

First, let's look at the procyclical component. Cyclical inflation is currently lower than would be expected given the unemployment gap (see chart 7). Core PCE inflation would rise 0.1 ppt to 0.2 ppt if cyclical inflation were to climb back to its Phillips curve model-implied level--or it could rise even further if the labor market continued to tighten (which is our base case from our most recent forecasts). One particular cyclical component that has deviated far below the past-cycle average is nondurable goods excluding food, gas, and clothing (see chart 8). This component constitutes 22% of core PCE, and if this were to get back to its 2002-2007 average of a 1.4% annual growth pace, it would directly add 0.1 ppt to overall core inflation.

Chart 7


Chart 8


Second, let's look at the acyclical components. We see potentially a 0.1 ppt lift to core PCE in the coming months from the non-health channel when benchmarked to the 2002-2007 average. This is based on the mean-reverting nature of the non-health component, meaning that any movement away from its benchmark level is likely to dissipate rather quickly (with shocks to it persisting for less than a year on average).

On the other hand, we don't expect the health channel of acyclical to revert back to 2002-2007 benchmark levels anytime soon because the evolution of health care inflation rates has more to do with government policies than the broader macro economy. It is likely that we have settled at a new lower normal for now because of the Affordable Care Act (ACA).

Health care services inflation was high during the early 2000s and then dropped sharply in late 2010. This drop reflects cuts to Medicare payments included in the ACA, which came into effect in fiscal-year 2011. These legislated cuts to Medicare payments can be an important restraining force on overall health care inflation, to the extent that the evolution of Medicare prices has both a large direct and indirect effect on overall health care prices--and one that will remain in place for the foreseeable future under current law.

Chart 9


After the Medicare cuts from the Affordable Care Act were phased in, health care inflation dropped precipitously. Inflation remained stable at the new lower level for several years, until prices were hit by a series of one-time policy shocks that brought them further down(10). Public payment growth rose somewhat over the past year as some of the legislated cuts were removed (Medicare and Medicaid reimbursement rates were raised more briskly to keep the system working). However, many of the legislated payment changes are permanent or in effect for several more years, implying that health care services inflation is likely to remain below its previous-cycle benchmark for some time.

Furthermore, the following are all factors pointing to persistent lower inflation on the health care price index:

  • The ending of individual mandate (keeping demand growth at a stand-still and offsetting upward pressure on higher insurance cost),
  • The growing provision of medical services by retailers (and developments such as the CVS-Aetna merger) (supply-side channel),
  • Bilateral political pressure against high drug prices (political channel), and
  • Drug product life-cycle and the resulting availability of cheaper, generic substitutes (patent channel) which are independent of economic cycles.

All in all, we see at least 0.3-ppt climb in core PCE in the next several months, which would put it at 1.9% (versus today's 1.6%). Additionally, tariff hikes on $200 billion Chinese imports that went into effect in June also put additional upside pressure at the margin temporarily (a one-time level effect). Our survey of corporate sector experts from S&P Global Ratings also suggests most corporate sectors are likely to face stable to increasing input pricing pressure in the coming months--manageable either through productivity gains or pass-through to customers, albeit with diminishing scope (see table 1 in Appendix).

After all is said and done, from a bottom's up perspective, we are still looking at core inflation getting back up to the Fed's 2% target by the spring of 2020.

Monetary Policy--Fine Tuning Stance

Still, even as inflation looks to get back to the Fed's 2% target in the coming months, it looks like the Fed will opt for a 25 basis point (bps) rate cut this quarter, with several Fed members signaling a July cut in the cards.

The Fed is more concerned about the possibility that weaker growth going forward (at home and globally) will weigh on future inflation, and the Fed may also be worried about repercussions from financial market repricing if at least one 25-bps cut is not delivered (see Appendix for broader arguments for monetary easing).

Setting aside the fact that the fed funds futures market has had a spotty record in predicting the eventual path of policy rate, do we think there is a case for interest rate cuts totaling 75 bps this year, as priced in by the markets? No. A 75-bps rate cut (cumulative) seems inconsistent with what seems to be the general assessment of the state of the economy--our assessment, and more importantly, the Fed's assessment. In the words of Fed Chairman Jerome Powell, the economy remains in "a very good place." It would also not be consistent with recommendations from the Fed's standard reaction function rules collectively (the Fed does not mechanically adopt the recommendation from any single rule).

What would likely force the Fed's hand to make 75 bps cuts?

While we don't rule it out, to get to a 75-bps cut in the federal funds rate, we would need to see fairly substantial evidence (which we don't currently) that the impact of an adverse trade policy shock and recent softness in the manufacturing sector and interest-sensitive housing sector is filtering through to the wider economy more rapidly. The economy has to slow down enough to push unemployment higher. The lack of any meaningful rise in unemployment claims (a leading indicator of the labor market), however, suggests that claims of an imminent sharp slowdown remain premature. Recent data on manufacturing (from June) shows early signs of stabilization, while housing starts are starting to move back to their levels before last year's steep slump (mortgage rates have also become more favorable).

There have been other broader arguments put forth for a series of rate cuts (see "Broader Arguments For A Rate Cut" in Appendix). The decline in financial-markets-based inflation expectations from October 2018 to June 2019 was one such concern that stands out as a risk to actual inflation. The contours of financial-market-based inflation expectations appear to have mirrored the changes in oil prices. Our estimates suggest monthly oil price moves explained only 10% of the variance in U.S. five-year inflation expectations from January 2003 to August 2008, but around 68% of it from September 2008 to June 2019. In the last month, such measures have also rebounded. For example, since it bottomed out on the week of June 17 at 1.77%, and the five-year inflation swap rates, five years ahead (often called 5y5y) inflation expectation rate has steadily moved up to the current level of 2% (see chart 10). Moreover, a recent study published in FEDS by Kim, Walsh, and Wei (2019) finds that when adjusted for time-variation in TIPS liquidity premia and inflation risk premia, longer-term inflation expectations suggested by breakeven inflation rates are higher and much less volatile than direct, unadjusted measures of inflation compensation. All the while, survey-based measures on inflation expectations of households and professional forecasters were stable (see chart 11).

Chart 10


Chart 11


In our view, the Fed has reached a "fine tuning" stage of the current monetary cycle, with rates within the range of Fed's estimates of longer-run neutral. At this stage, it is normal for the Fed to recalibrate policy 25 bps either direction to stay on a sustainable long-run pace of growth that is consistent with a 2% inflation path. At least, this is what their long-held (and publicized) reaction function suggests.

A little lower than target inflation would not be the worst thing if nominal interest rates were higher, but it further hinders the FOMC's ability to cut real rates come the next recession with nominal rates also already low--an issue the Fed is thinking about intently as it undergoes its current review of policy, strategies and tools. To this point, there are signs that the FOMC's thinking on inflation is changing. The Fed is concerned that the current policy framework is producing a bias toward shortfalls in inflation relative to the central bank's symmetrical 2% inflation target, or an alternative target based on the price level rather than inflation. It is possible that such a price level rule--which implies a significant shortfall below 2% a year cumulative path for prices during this expansion that should be reflected in lower policy rates--is beginning to already influence the thinking of some FOMC members. If that's the case, we may get a series of rate cuts in the coming months--and it wouldn't just be fine-tuning.

For now, given ongoing crosscurrents facing the U.S. economy, the Fed is leaning toward a modestly more accommodative stance relative to earlier in the year to keep the economy on an even keel on that longer-run growth path, which we estimate to be around 1.8%. It is fine-tuning, not a reaction to a turn in the business cycle.


Table 1



The estimate two equation inflation model:

(1) Core inflation (t) = 0.31inflation expectation (t) + 0.29coreinflation (t-1) + 0.28coreinflation (t-2) – 0.07slack (t) + 0.24RPIM (t) + error

(2) Inflation (t) = core inflation (t) + weighted RPIE (t) + weighted RPIF (t)

The model combines an identity for the change in the price index for total personal consumption expenditures (PCE) (equation 2) and a simple reduced-form forecasting equation for core PCE inflation (equation 1), where inflation and core inflation denote year-over-year percent change of the respective price indexes, RPIE and RPIF are annual growth rates for prices of energy and food components, respectively, both expressed relative to core PCE prices and weighted by their share in total consumption.

In the core inflation equation, inflation expectation is represented by University of Michigan's one-year forward expectations by households. Households may not be able to correctly identify the current level of inflation, but they have a fairly good understanding of changes in the trend of current inflation and that these changes are likely to inform their expectations about future inflation. Slack denotes the level of labor utilization calculated as unemployment rate less CBO's long-run natural rate of unemployment, and RPIM controls for the effects of changes in the relative price of core imported goods, defined as the annualized growth rate of the price index of non-energy imported goods less the annual core PCE inflation all multiplied by the share of nominal core imported goods in nominal GDP.

Non-fuel import price inflation model:

Import price growth (t) = 0.68import price growth (t-1) – 0.09 trade-weighted nominal effective exchange rate (t) + 0.61trade weighted Global PPI (t) – 0.42trade weighted Global PPI (t-1) – 0.30

Where we construct trade weighted Global PPI that combines Canada, Mexico, China, Japan, the eurozone, and the U.K.--the top trading partners of the U.S..

Chart 12


Table 2

Major Spending Categories Broken Down By Procyclical Versus Acyclical Type
Procyclical Acyclical
Housing Motor vehicles and parts
Other nondurable goods Furnishings and durable household equipment
Food services and accommodations Recreational goods and vehicles
Recreation services Clothing and footwear
Nonprofit institutions serving households Health care services
Transportation services
Financial services and insurance
Other services
Other durable goods
Source: Mahedy and Shapiro's (2017) “What’s down with inflation?,” San Francisco Federal Reserve.

Chart 13


Chart 14


Related Research

  • Diane Alexander (2018), "The Recent Rise in Health Care Inflation," Chicago Fed Economic Letter, IL.
  • Don Kim, Cait Walsh, and Min Wei (2019), "Tips from TIPS: Update and Discussions," FEDS Notes, Board of Governors of the Federal Reserve System.
  • Janet Yellen (2015), "Inflation Dynamics and Monetary Policy," Speech at the Philip Gamble Memorial Lecture, University of Massachusetts, Amherst, MA.
  • Tim Mahedy and Adam Shapiro (2017), "What's Down With Inflation?," Economic Letter From Federal Reserve Bank of San Francisco, CA.
  • Yasser Abdih, Ravi Balakrishnan, and Baoping Shang (2016), "What is Keeping U.S. Core Inflation Low: Insights from a Bottom-Up Approach," International Monetary Fund Working Paper.


(1) Produced by the U.S. department of Commerce, as opposed to the Consumer Price Index (CPI) inflation, which is produced by BLS. In general, the PCE tends to report somewhat lower inflation than CPI--PCE inflation has tended to run about 30 bps to 40 bps below CPI inflation. The CPI probably gets more press, in that it is used to adjust social security payments and is also the reference rate for some financial contracts, such as Treasury Inflation Protected Securities (TIPS) and inflation swaps. The Federal Reserve, however, states its goal for inflation in terms of the PCE.

(2) The PCE report generally runs two weeks behind the CPI report. The two measures, though following broadly similar trends, are certainly not identical. Key differences arise from (i) weight effect--differences in how they weigh items based on survey population (the CPI is based on a survey of what households are buying; the PCE is based on surveys of what businesses are selling); (ii) scope effect--the CPI only covers out-of-pocket expenditures on goods and services purchased. It excludes other expenditures that are not paid for directly, for example, medical care paid for by employer-provided insurance, Medicare, and Medicaid. These are, however, included in the PCE; and (iii) formula effect--the indexes themselves are calculated using different formulae. The PCE tries to account for substitution between goods when one good gets more expensive, while the CPI keeps the basket more or less unchanged.

(3) Contributing to the rise in the core CPI in June were increases in the indices for new vehicles (0.1%), shelter (0.3%), household furnishings (0.3%), apparel (1.1%), and used cars and trucks (1.6%). Both the apparel and the used cars and trucks indices had declined in recent months.

(4) The trimmed mean PCE price index has been shown to be better than core PCE as a real-time tracker of long-run headline inflation trend since the 2000s, and it also better captures the part of inflation that varies with the business cycle.

(5) The dot-com boom; the investment and stock market drops that followed; the 2001 recession; the 9/11 terrorist attacks; China joining WTO in 2001; the start of the euro as a full-fledged currency in 2002; the housing price bubble; unemployment below NAIRU and well above NAIRU in the recession; interest-rate hikes to above 5% for a year from mid-2006 to mid-2007 and the subsequent decline to zero bound; the Great Recession that started in 2008 after the financial crisis in September 2008; large federal budget deficits and the quantitative easing that followed.

(6) It could be that the declining sensitivity of unemployment gap reflects NAIRU that is actually lower than what is estimated by the CBO-- rate of unemployment consistent with stable inflation may change over time in response to globalization, variations in productivity growth, wage setting institutions, expectations, and other factors. Relatedly, that is why it is argued that looking at price and wage inflation is a more reliable gauge of slack than comparisons of employment rates over time--even if these comparisons are done carefully by adjusting for age.

(7) Nonfuel import prices, before accounting for the effects of tariffs on the price of imported goods, have continued to decline from their mid-2018 peak, responding to dollar appreciation, lower foreign inflation, and declines in non-oil commodity prices. In particular, prices of industrial metals have fallen in recent months, partly on concerns about weak global demand.

(8) See, for example, Gopinath 2015; Gruber, McCallum, and Vigfussion 2016; Abdih, Balkrishnan, and Shang, 2016.

(9) "What's down with inflation?" November 2017 and "Has inflation sustainably reached target?" November 2018, published San Francisco Federal Reserve Letters.

(10) In addition to Medicare payment cuts in the ACA, there were three large shocks to the market that likely contributed to the exceptionally low levels of health care services inflation seen from 2014 to 2016. First, the Budget Control Act of 2011 contained a package of automatic spending cuts, which was triggered when the U.S. Congress Joint Select Committee on Deficit Reduction failed to reach a bipartisan agreement to cut spending. As a result, the act required automatic reductions in federal spending ("sequestration"), which for Medicare took the form of an across-the-board cut of 2% to Medicare payments. The cuts went into effect in April 2013 and applied to Medicare payments to both hospitals and doctors. Second, the Medicaid expansion under the ACA went into effect in 2014 and resulted in a dramatic increase in Medicaid enrollment. Medicaid payments are lower and grow more slowly than payments from other payers. Therefore, the ACA expansion shifted the composition of payment. Third, in January 2015, the Medicaid primary care rate increase expired, leading to sharp reductions in Medicaid payments to primary care doctors in 2015.

(11) A counter argument to the idea that wage growth has picked up but is still below the rates seen in the late 1990s is that this slower growth is not necessarily evidence of a slack labor market. Productivity growth is running around 1%, compared with about 3% in the late 1990s, which explains lower wage growth. Recent wage gains have been fastest for workers in the bottom quintile. Overall, this is what a hot labor market looks like in an economy that still suffers from low productivity growth.

(12) Operationally, the Fed has landed on 1.7% as the inflation average over the past 25 years, thus making neutral rate (in real terms) appear about 30 bps lower than what the inflation target of 2% would suggest. That means we are already at neutral with today's 0.7% (2.38%-1.7%), and increasing or decreasing 25 bps from here onward is going to be only normal.

The views expressed here are the independent opinions of S&P Global's economics group, which is separate from, but provides forecasts and other input to, S&P Global Ratings' analysts. The economic views herein may be incorporated into S&P Global Ratings' credit ratings; however, credit ratings are determined and assigned by ratings committees, exercising analytical judgment in accordance with S&P Global Ratings' publicly available methodologies.

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