The Federal Reserve’s new chairman was keen to keep the markets sweet when he presided over its interest rate-setting committee for the first time last week.
Jerome (Jay) Powell and colleagues presented an upbeat picture of US economic prospects, reporting that activity has strengthened in recent weeks. Gross domestic product (GDP) for the first quarter of 2018 is now expected to come in at 2.7%, rather than the 2.5% rate forecast last December. For 2019, the Fed’s team currently foresees a growth rate of 2.4%.
The chief’s reviews for his first major post-promotion press conference were generally favourable, even if one analyst remarked of his performance: “Powell is good at seeming to answer questions directly while giving away very little.”
The Fed also shows few signs of worry in its outlook for inflation, although its growth projection is well above 1.8% – the rate it views as consistent with stable inflation. In Powell’s own words: “There is no sense in the data that we are on the cusp of an acceleration in inflation,” and his team is “very alert” to any upward pressure resulting from the current low US unemployment rate.
Measures of inflation
So, while inflation is expected to edge higher it is also seen as staying reassuringly close to the Fed’s target of 2%. Members of its rate-setting committee have indicated they expect a modest overshoot before the rate stabilises, with inflation rising to 2.1% next year and staying there until the end of 2020.
It should be mentioned that as with other major economies, the US has more than one measure of how swiftly prices are rising.
Best-known is the consumer price index (CPI), which measures the cost of a basket of goods and services, including housing costs. In February, the CPI was up 0.2% on the month and 1.8% from a year earlier, having gradually edged up from near-zero over much of 2015.
The Fed’ own preferred measure of inflation is the slightly more sophisticated personal consumption expenditures (PCE) index. This tends to show a lower rate than the CPI and reflects what businesses are charging for their goods and services. It also revises the spending categories measured more frequently. The core PCE jumped by 0.4% in January this year, but that wasn’t enough to push the annual rate up from 1.5%.
It is generally agreed that Powell and colleagues won’t be too dismayed if US inflation moves above the Fed’s 2% target, provided that the overshoot is only modest and helps keep the motor of US economic growth running smoothly for several more years.
“Let me be clear: a small and transitory overshoot of 2% inflation would not be a problem,” said William Dudley, president of the Federal Reserve Bank of New York, back in January. “Were it to occur, it would demonstrate that our inflation target is symmetric, and it would help keep inflation expectations well-anchored around our longer-run objective.”
His view is echoed by Neel Kashkari, president of the Federal Reserve Bank of Minneapolis. Kashkari notes that US inflation has hovered around 1.5% for the past five or six years, so if the Fed “is serious about a symmetric 2% price target” he suggests it shouldn’t be any great concern if it now runs a little above target for the next five.
But could the Fed’s relaxed stance on inflation turn out to be too complacent, with the rate moving higher than it expects? Some analysts believe that the corporate tax cuts pushed through by president Trump, which received the green light last December, are taking time to feed through but will eventually push inflation higher.
However, while the US jobless rate is already down to 4.1%, its lowest since the end of the dotcom boom in 2000, there is little sign of inflation-busting pay deals. Average hourly earnings in February rose just 0.1% from the previous month and the year-on-year rate is only 2.6%.
Given that America’s jobs market is at or close to full capacity, more generous pay settlements could lie ahead in some sectors if skill shortages start to develop. The Fed believes US unemployment could be as low as 3.5% next year – a full percentage point below the 4.5% rate at which it regards wage-related inflation as likely to accelerate.
Meanwhile some of the nation’s major food groups, such as breakfast cereals producer General Mills, report that higher costs for shipping, oil and other commodities are putting the squeeze on their profits and their prices could rise in response.
Grocery shoppers have recently felt the benefit of Amazon’s $13.7bn acquisition last June of upmarket supermarket chain Whole Foods. Its prices have been trimmed to stem the loss of sales to lower-priced rivals – a recent report suggests a basket of 25 items from the store costs 6% less under the new owner – but supermarket price wars are unlikely to be prolonged if earnings are seriously dented.
Trade war fallout
A bigger threat could lie in president Trump imposing further heavy tariffs on imported items, such as those already slapped on steel and aluminium from China.
The prospect of an all-out trade war between the US and the rest of the world, marked by tit-for-tat retaliation, would be bad news for inflation on both sides of the Atlantic. China has already threatened to respond by slapping tariffs on US wine, fruit, steel pipes and other exports.
Bloomberg Economics forecasts that a no-holds barred trade war could cost the world’s economies around $470bn by 2020. More ominously for the US, if things got ugly China could also respond by scaling back its purchases of US Treasury debt. The world’s second-biggest economy is the US’s biggest creditor.
China’s willingness to purchase US debt helps keep a lid on the steadily rising federal government deficit. Should its appetite seriously wane, the interest rates paid by the US government on those bonds would need to rise steeply to attract alternative investors – with serious knock-on effects for inflation.