Despite high commodity price inflation, tight labour markets and rising import prices there has, so far, been little evidence of inflationary pressures feeding through to goods prices and into the core consumer price level in the US. However, in this report we argue that there are clear signs that significant inflationary pressures have been accumulating in the inflation pipeline. These pressures are now on the verge of popping the surface implying rising goods price inflation in the coming quarters.
Firstly, the anchor for core goods prices, unit labour costs, has been slowly climbing as a response to the tightening of the labour market. This slow - but steady - upward trend in labour costs is the real long-term danger for the US economy, and we think it is underestimated in the market at present.
This is partly because the expansion in the 90s left the impression that inflation was and is restrained by globalisation. We show that the low inflation in the later part of the 90s cycle was actually mostly a cyclical phenomenon attributable to the deflationary impact from the Asian crisis in 1997-8.
Secondly, the rise in commodity prices and weakening of the dollar during the past 12-24 months is about to feed through to higher US goods price inflation. This follows the usual lag of about 12 months.
Consequently, we expect core PPI inflation to accelerate above 3.0%. In combination with higher import price inflation this will add 0.3-0.4%-point to core CPI/PCE inflation. However, the overall path for core inflation will be flat - not rising - as the higher goods price inflation will be countered by a normalisation in housing-related inflation.
Hence, core CPI inflation will go sideways continuing in the higher end of the implicit Fed comfort zone during the coming year. However, as housing services make up a smaller share of the PCE price index, core PCE inflation is likely to drift slightly upward during the coming quarters.
Goods price inflation is less dead than it seems
High core inflation, but not yet driven by goods
The pick-up in US core inflation (consumer prices index ex. food and energy) in 2006 was largely a result of higher imputed housing inflation, which boosted the rent-of-shelter component - a development we forecasted and explained in the report Research USA: Core inflation to rebound, January 2006.
Looking forward housing-related inflation is likely to recede somewhat, cf Global Scenarios, June 2007. Indeed, Fed Chairman Ben Bernanke has said that this is part of the reason why he expects US inflation to fall back this year.
So far there has been little evidence of inflationary trouble in goods prices in the US. This is despite high commodity price inflation, tight labour markets and rising import price inflation.
Overall this seems to lead to a simple comforting analysis: The rise in US inflation was entirely due to a rise in housing-related inflation. This was again partly of a technical nature, partly due to a strong housing market. With the housing market tanking, this inflation component should subside, revealing a benign fundamental inflation picture for goods and non-housing services.
However, there is much more trouble brewing, especially for goods prices. Indeed we forecast a substantial rise in goods price inflation over the coming 12 months - enough to offset the drop in housing-related inflation and to keep the Fed worried.
Below we argue that there is upside pressure in the goods price pipeline. The implication will be a pick-up in core PPI in US goods price inflation from 1.5% to above 3.0% y/y. This will imply an upward impact on overall annual core PCE/CPI inflation of +0.3-0.4%-point, broadly countering the downward drag from slowing housing-related inflation.
Why goods price inflation will rise now
To understand why we are getting worried about goods price inflation in the US, we take a step back and take a look at how the US inflation process works for goods, cf. the following chart.
US goods inflation is sensitive to both domestic and external price trends. However, in the long run producer prices excl. energy are anchored by US unit labour costs.
This is not surprising, as labour is by far the dominant cost component for US producers.
However, one would expect swings in external prices competition to also affect US goods price inflation - at least in the short run. These external price swings would come through exchange rates, global finished price trends and commodity prices.
Consequently, we would expect divergences between core finished goods PPI and growth in manufacturers unit labour costs (ULC) to be driven by the impact from the effective dollar, commodity prices and global finished goods prices.
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