The recently released January consumer price index surprised investors to the upside. Both the headline and core readings rose more than expected on broad-based gains: the former rose 0.5 percent while the latter rose 0.3 percent.
The larger-than-expected increases were probably payback from previous weakness, as the year-over-year changes were essentially unchanged. Over the last 12 months, the headline is up 2.1 percent, the same rate as December and down sharply from the 2.5-percent year-over-year rate that prevailed last year at this time.
{mosads}Regarding the core, it is now up 1.8 percent over the past 12 months compared to 1.7 percent in December. But the year-over-year growth rate is still below where it was in January 2017 (2.3 percent).
Inflation is hardly an issue at this point, which is perhaps why the stock and bond markets, after initial negative reactions, quickly reversed course. Put another way, the financial markets are looking past the recent inflation data, as they rightly should.
For monetary policymakers, the inflation gauge of choice is the personal consumption expenditures price deflator, or the PCE deflator for short. This series historically has shown even less inflation than the consumer price index.
For example, the core PCE deflator, which strips food and energy prices out of the headline, has consistently run 30 to 40 basis points per annum below the core consumer price index. Indeed, the core PCE deflator is seldom at the Fed’s desired 2-percent target.
Since June 2009, when the recession ended and the economic recovery began, the core PCE deflator has increased at just a 1.6-percent annualized rate. Over the last 12 months, the increase has been one-tenth lower at 1.5 percent.
In fact, during the current business cycle, the core PCE has been 2 percent or higher only briefly. It happened from December 2011 to April 2012. If the Fed wanted to make up for this consistent undershooting of inflation, the core PCE in theory could run at a 2.5-percent annualized rate over the next seven years.
The last time the core PCE grew 2.5 percent on an annual basis was 1993. Essentially, the U.S. economy has been a low inflation environment ever since, despite several business cycles and periods of sub-4-percent unemployment and surging wage gains. Federal Reserve policymakers should heed history’s recent lesson.
With inflation having consistently surprised to the downside, there is little risk in the Fed allowing the economy to run a bit hot, especially if it helps galvanize upward wage pressure.
After all, the risk of tightening too soon on an inflation boogeyman that might not exist is far worse than having to tighten rates later to dampen inflation pressure. Monetary policymakers have far more experience with the latter scenario. It is no wonder then that financial markets are looking past upside inflation risk. Hopefully, the Fed will, too.
Joseph LaVorgna is the chief economist for the Americas at Natixis, an international corporate and investment banking, asset management, insurance and financial services arm of Groupe BPCE, the 2nd-largest banking group in France with 31.2 million clients spread over two retail banking networks, Banque Populaire and Caisse d’Epargne.