New data should curb fears of skyrocketing inflation

Forget Valentine’s Day cards and sweets. On Wednesday morning, all eyes were fixated on the Bureau of Labor Statistics’ January consumer price report.

The question du jour was whether the January wage growth acceleration to 2.9 percent — the fastest since June 2009 — observed a couple of weeks earlier in the nonfarm payrolls report would be confirmed by inflation data.  

{mosads}Taken at face value, the consumer price index (CPI) seemed to confirm the stronger inflation trend observed in the nonfarm payroll report.

Headline consumer prices posted a surprisingly strong 0.5-percent uptick in January, well ahead of consensus expectations for a 0.3-percent increase, while core prices (stripped of the volatile energy and food components) rose a solid 0.3 percent.

Considering the details however, the picture is more nuanced. Energy prices rose a strong 3 percent as gasoline prices surged nearly 6 percent. On its own, the volatile energy component added 0.2 percentage points to the headline CPI print.

Further, while the significant 0.3-percent increase in the core price index also surprised to the upside, it appears some ad-hoc factors temporarily boosted the monthly advance. For instance, apparel prices jumped 1.7 percent in January — the strongest monthly jump since 1990 — adding 0.1 percentage points to both headline and core CPI.

Taking a broader perspective then, headline CPI inflation remained unchanged at 2.1 percent, year-over-year in January — in line with its average pace in 2017 — while core CPI inflation remained steady at 1.8 percent — also in line with its 2017 average.

Factoring those elements, the excessive worries about inflation suddenly spiraling out of control are replaced with a broader understanding that inflation is continuing to gradually firm in the face of a strong economy, reduced spare capacity and a stronger wage-inflation, push-pull dynamic.

As such, what we are observing in financial markets is a healthy repricing of inflation expectation and Fed tightening in the coming months.

Tuesday’s 10-basis-point increase in the 10-year Treasury yield to 2.90 percent reflected this repricing. It also reflects market adjusting to the reality of an increasingly fiscally-stimulated U.S. economy in 2018 and 2019.

Oxford Economics estimates that the combination of the Tax Cuts and Jobs Act and the Bipartisan Budget Act will add 0.7 percentage points to growth in 2018 and 0.5 percentage points to growth in 2019.

The fiscal boost to a late-cycle economy will simultaneously bring about further inflationary pressures, which along with a rising budget deficit, will continue to pressure long-term rates higher.

For the past few months, Oxford Economics has been indicating that 2018 would mark the year when U.S. inflation would approach the Federal Reserve’s 2-percent inflation target. While the headline and core personal consumption expenditures (PCE) deflators will take a little longer to reach the target, this will likely happen in early 2019.

In the context of financial markets, this last point is of extreme importance. Given the slightly more hawkish composition of the Federal Open Market Committee in 2018 and the fact that PCE inflation is moving toward 2 percent, the Fed is likely to raise the federal funds rate four times this year.

Doing so will require careful commination from the Fed to avoid adverse market shocks. However, after managing to increase rates three times in 2017 without significant market stress, implementing four rate hikes in 2018 when inflation is closer to its objective should not prove excessively traumatizing.

Gregory Daco is the chief U.S. economist for Oxford Economics.