A perfect storm of inflation myths
Peter Warburton - 16 May 2019
In the past 9 months financial markets have been subjected to a perfect storm of inflation myths. The global inflation trend is little changed from last summer: the US is not the world. The prospects of an inflationary resolution – in the US and the world – over the medium-term have risen over the past few months, not fallen. The growth of the US GDP deflator is running above private consumption expenditure (PCE) inflation because the contribution from net exports is inflationary and expected to become even more so. The cyclical component of US PCE inflation has not abated; it is the idiosyncratic components that have delivered the lower readings. Finally, price indexes contain seasonal biases and should not be annualized.
Myth 1: The US sets the trend of global inflation
Over the past decade or so, this is demonstrably false. There is compelling evidence that inflation brews at the base of global supply chains and percolates towards the apex. Specifically, energy and food price shocks are absorbed much more quickly in emerging than mature markets. Figure 1 shows that global GDP-weighted price measures have anticipated the direction of US inflation since 2008. By dint of global outsourcing, the US has become a price-taker.
Source: Economic Perspectives
Myth 2: Global inflationary prospects have dimmed
Suffice to say that the political threat, in the US and Europe, to current central bank inflation objectives and inflation-targeting frameworks, has escalated in the past 6-12 months. The Richard Clarida review of US monetary policy and its communication is little more than a sticking plaster over the wound. The ECB is madly casting around for new ways of re-setting inflation expectations to the upside.
Myth 3: The US PCE deflator is the one to watch
The US Federal Reserve is the only central bank we know that prefers the PCE deflator to the consumer price index as a timely measure of inflation. The CPI has its own flaws, but at least it is never revised as the PCE is. The detail of the PCE is only available on a quarterly basis and is also subject to revision. If national accounts measures are judged preferable, then why would you not use the GDP deflator, which is comprehensive? As figure 2 reveals, the contribution of net exports to the GDP deflator tends to move antithetically to the PCE, dampening the swings.
Data source: US Bureau of Economic Analysis
Myth 4: US inflation is heading lower because the economic cycle has turned down
As Frankie Howerd used to say, “No, no and thrice no!” Inflation has structural and idiosyncratic components as well as cyclical ones. Cyclical inflation is a lagging indicator, following a loss of economic momentum typically by around 6 months. It is no surprise, therefore, that the San Francisco Fed’s decomposition of US PCE inflation (figure 3) finds that acyclical – mostly idiosyncratic – components are responsible for the recent softness.
Figure 3: Cyclical and acyclical core PCE inflation
Source: San Francisco Federal Reserve
NB Cyclical and Acyclical Core PCE Inflation updates data on the contributions to core personal consumption expenditures from cyclical and acyclical components, based on the methods described in Mahedy and Shapiro (2017).
Myth 5: Inflation data is fully seasonally adjusted
Seasonal adjustment of prices was difficult enough when all retailers were bricks-and-mortar and clearance sales were dependably regular through the calendar. Today, pricing is dynamic and responsive to a thousand external influences as global supply chains twist and turn, break and mend, lengthen and shorten in real time. The US practice of annualization of quarterly price movements makes no sense. The noise greatly outweighs the signal. Trading or investing on annualized inflation data will prompt a sequence of knee-jerk reactions.
As the perfect storm of inflation myths blows over, there will be time for sober reflection on the global inflationary trend and, perhaps, some hearty snacks for the seagulls in its wake.
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