Currently the markets are deeply focused on inflation. More specifically…the lack of it as wages have risen, growth has picked up and the labor market has tightened. Core PCE has dropped to 1.55% recently. Is this a sign of underlying weakness in the economy that the Fed should respond to?
In our view, no. This San Francisco Fed Economic Letter from a couple of years ago should be the guidepost.
They split inflation into procyclical and acyclical components. Procyclical components generally have moved in tandem with the economic cycles, prices rising as the economy booms and falling when it weakens. The acyclical components dance to their own tune. They concluded that procyclical inflation had returned to its pre-recession level, while acyclical inflation had remained low, driven by idiosyncratic factors. The data are updated through March 2019 in the chart below. The white line is procyclical, orange line is acyclical.
Source: Bloomberg
Procyclical inflation is running at 2.5%, up a little over the past 6 months. Acyclical inflation is where the drops are. It has fallen from 1.8% to 0.9% over the past 6 months. As the San Fran Fed says, it is still being driven by drops in health care costs. There is no economic signal for the Fed to worry about here, and easing policy to remedy makes little sense. More broadly, commentators hoping for health care inflation to go back to the levels of a decade ago in order for the Fed to hit a policy goal are out to lunch. The Fed has the granularity of data to see more clearly what is going on, it seems a shame this doesn’t get more air time. Mary Daly, the San Francisco Fed Chair, presented the case in New York recently – it would be good to see the issue at the forefront.
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