Tuesday, April 24, 2007

Inflation: The Latest US Import?

United States

April 20, 2007

By Richard Berner | New York

By any metric, US “core” inflation cooled significantly in March, renewing hopes for Fed ease and re-igniting risk appetite in global markets. Measured by the CPI, core inflation slowed to 2.5% in the year ended in March from 2.7% in February. Likewise, we estimate that measured by the core personal consumption price index (PCEPI) — the Fed’s preferred measure — core inflation slowed to just 2.1% in March. Both readings are fully 50 basis points (bp) below their peaks of last September, apparently putting inflation on track to come in at rates consistent with what the Fed deems to be price stability.

However, I think the March readings may represent a lull, and that some inflation risks are rising again. Like many other things these days, those risks are no longer entirely home grown; as in the 1970s, we may now be importing them from abroad. The upshot: Inflation has peaked, in my view, but there will continue to be flare-ups and the decline will still be gradual. Here’s why.

There’s no mistaking the decline in core inflation measured by the CPI over the past six months. While surging energy quotes drove up the headline rate to a 2.8% year/year gain in March — a seven-month high — the core rate decelerated to a ten-month low. Yet, three factors that depressed core prices in March were likely transitory, and all three may reverse in April. Seasonally adjusted hotel room rates plunged by 2.3%, as the actual increase failed by far to match the normal seasonal pre-vacation gains. Although such rates measured by the CPI rose just 1.3% from a year ago, hotel industry revenue per average room data suggest gains of 6-8%, so a rebound in the CPI version seems likely next month. Ditto for the 1% decline in apparel prices: This year they failed to match the normal increases accompanying the introduction of spring lines, and we suspect that a rebound is likely soon. Third, medical care goods quotes (mostly for prescription drugs) fell by 0.3% in March, marking the fourth decline in the last five months. With wholesale drug prices up by 3.5% in the last year, a rebound here also seems likely.

More important, several global factors seem likely to contribute to US inflation over the next few months. Among them: Strong global demand and limits on supply are boosting food and energy quotes. Energy quotes declined at an 11.5% annual rate in the three months ended in December, but jumped at a 22.9% annual clip in the three months ended in March. Food prices, meanwhile, have accelerated from a 2% annual rate in the September-December span to a 3.9% annual rate in the past three months. We believe that sellers typically pass some of these price hikes through to core prices with roughly a 2-4 month lag, via transport fares, some rents, and other goods and services. Just as the energy price declines of late last year may thus have modestly cooled core inflation in the past few months, so will the recent acceleration likely, if temporarily, refuel the core composite in coming months.

Perhaps more lasting, US consumer import prices are accelerating and the dollar’s recent decline may magnify their faster rise. Over the year ended in March, import prices for consumer goods other than motor vehicles and parts accelerated to 1.8%, the fastest pace in more than eleven years. The acceleration was broadly based, including in prescription drugs (from -0.9% to +2.5%, a 340 bp acceleration); toiletries and cosmetics (to 2.1%, a 200 bp swing); household goods (1.6%, a 140 bp swing); toys and sporting goods (up 140 bp to 1.4%). The dollar’s decline probably influenced that acceleration; over the past year, the Fed‘s broad, nominal trade-weighted dollar index declined by 3.4%. Not all of the dollar’s recent decline has yet shown up in quotes for imported goods, however. If the dollar continues to slide, especially against the Asian currencies and to some extent Europe, as we suspect, import prices likely will accelerate further, and add a tenth of a percent or two to consumer inflation.

Importantly, the slipping dollar isn’t the whole story. The boost to inflation from a weaker dollar has dwindled over the past two decades, reflecting weakening links between exchange rate changes and import prices and ultimately consumer prices. Several Fed economists in a paper last year found that the decline is a global phenomenon. Across G7 currencies, their work suggests that exchange rate pass-though to import prices has declined to 40% over the past 15 years from 70% in the 1970s and 1980s, and in the US, it has declined to only 30% (see Jane Ihrig et al. “Exchange-Rate Pass-through in the G7 Countries,” International Finance Discussion Paper 851, January 2006). That is, a 10% sustained depreciation in the dollar might, other things equal, boost the import price level by 3% over a 2-3 year period.

The empirical fact that such exchange-rate “pass-through” has apparently weakened over the past several years, like the flattening in the Phillips curve, may reflect good monetary policies. As well, it probably results from the globalization of markets and production that has promoted “pricing to market.” That is, exporters not wanting to surrender market share have more closely matched domestic-origin prices in setting their export prices in foreign currency, and they tend to hedge their currency risk either ‘naturally’ by sourcing abroad or financially. That probably muted the pass-through and lengthened the lags from currency moves to changes in relative prices long before the dollar began its descent.

Notwithstanding disinflationary monetary policy, I also suspect that the pass-through link varies with the cyclical state of the global economy and inflation expectations. Considering those factors, the weaker dollar may explain half the recent increase in import prices. And the booming global economy may have accounted for the other half, by increasing the pricing power of exporters to the US. Looking ahead, the combined effect of the dollar’s decline and the global boom on US inflation now could be larger than it was over 2002-04 (for more discussion, see “The Dollar and Inflation,” Global Economic Forum, May 5, 2006). The cyclical state of the domestic economy also matters for assessing the impact of all these global factors on US consumer price inflation. Despite the sluggish pace of US economic activity over the past year, the level of resource utilization is still high, and sellers may thus succeed in passing such price hikes through to consumer inflation.

Global factors — higher energy and import quotes and a weaker currency — may also contribute to US inflation by reviving inflation expectations. So far, however, there’s little sign of that: Inflation compensation measured by 10-year TIPs spreads plunged by 10 bp on this week’s good inflation news, to 240 bp. To be sure, the reaction in distant-forward breakevens was more muted, amounting to 3-4 bp, hinting that these developments haven’t much altered market participants’ underlying inflation expectations. In mild contrast, survey-based inflation expectations, such as the measure of 5-10 year expectations compiled by the University of Michigan ticked up to 3% in March. But it’s early days for assessing the impact of these developments on expectations.

The most important factor affecting inflation expectations is back home: The Fed. Clear goals and objectives and a straightforward sense of how the Fed will get there are both critical to anchoring longer-term inflation expectations. And by an large, the Fed has been successful in doing exactly that over the past several years. Lately, however, when the Fed says inflation is too high, market participants aren’t sure how to calibrate such statements. That’s partly because there has been some ambiguity over the Fed’s implicit inflation objective.

Officials have described their preferences in terms of a 1% to 2% “comfort zone” for core PCE inflation, but for three years, core PCEPI has run above the upper end of that zone. Many market participants thus assume that officials’ de facto target is 2% and not the 1½% mid-point of the “comfort zone.” If the Fed were clearer about this critical issue — whether they pick one or the other — I think it would more firmly anchor inflation expectations. Personally, I prefer 2%, because it builds in a bigger cushion for measurement error and disinflationary shocks (see “More Clarity, Less Guidance From the Fed,” Weekly International Briefing, March 30, 2007). Either way, together with a set of global factors potentially pushing up inflation expectations, lingering questions about the Fed’s objectives may translate into market uncertainty, pushing up term premiums and steepening the yield curve.

That steepening seems to be irregularly underway, and is becoming a popular trade. Some investors are assuming that the Fed now has a green light to ease and thus look for a bullish re-steepening. Fixed-income markets now discount a better-than-even chance of a cut by September for the first time in about a month. Don’t count on it: “Base effects” may cap year-on-year inflation for now, since comparisons with last spring are tough. But one month’s good inflation data won’t likely be sufficient to convince the Fed that the risks are balanced, and officials also may worry that global fundamentals are no longer disinflationary. Instead, the curve may steepen bearishly as term premiums rise and inflation prints turn a bit less favorable. Investors in that context should also consider TIPs. They’re more attractive now with some inflation upside, and seasonal “carry” is now relatively favorable (because TIPS are priced off the headline CPI before seasonal adjustment, and the seasonal upswing in gasoline and energy quotes is still underway). According to Morgan Stanley Interest Rate Strategist George Goncalves, 10-year TIPS are priced for a widening of about 12 basis points from current levels. I’m willing to bet that inflation surprises could easily take spreads higher.

There are risks in both directions, however. A rebound in inflation could quickly undermine today’s financial-market bullishness. The threat of protectionism could add another layer of risk to the inflation outlook, because it would block competition in US markets from cheaper overseas goods and services. Escalating protectionism, moreover, might extend and/or intensify the dollar’s recent decline. Perhaps the biggest irony in this context is that while many believe that globalization will be eternally disinflationary, courtesy of ever more tightly-integrated global supply chains and other global spillovers, globalization in these circumstances may have — at least for now — turned into an inflation tailwind.

Richard Berner

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