It is a reflection of the diverse country backgrounds of the Macro Matters team (or international experience as a football agent would put it) that hardly anyone knew the song titles I used in a recent internal note on US inflation. They were all Pulp songs. Clearly “Cool Britannia” wasn’t as big a hit globally as Tony Blair led us to believe. Or maybe Pulp weren’t even big outside of their and my home county of Yorkshire! Their lead singer did infamously invade a live Michael Jackson performance though!
The reason I chose Pulp was that I could make a pun of their title track “This is hardcore”. I inserted a comma and called the note "This is hard, core". Because, forecasting US core inflation is, indeed, hard.
The chart below shows one that US core inflation (i.e. excluding food and energy) has risen over the past year, in line with our model prediction… or has it? It depends which measure you use.
The core measure of the CPI (consumer price index) has risen and is broadly in line with the average of the past 20 years. So why isn’t the Fed making a fuss about this and hiking rates? Because its preferred measure of inflation - the core PCE deflator (Personal Consumption Expenditure) - remains subdued and below the Fed’s 2% target.
Why are the two inflation measures diverging? The main reason is rental costs. Rent has a weight of around 30% in the CPI, double the 15% weight in the PCE. And the US housing market is very tight. The rental vacancy ratio is the lowest since 1986 (chart below), suggesting the glut of houses built in the post-Britpop decade has clearly been run down. So rental inflation is running at 3.8%, above its 20-year average rate of 3.0%.
The rental vacancy rate is one of the inputs into our US core inflation rising-or-falling model, alongside GDP growth, commodity prices, the exchange rate, economic slack and globalisation.
Our model for US core CPI is currently pointing to a slight firming in inflation, and a faster acceleration by mid-2017 when the lagged effect of weaker commodity prices drop out.
By contrast, our model for core PCE still points to lower inflation in the short run as the boost from rising rents is less pronounced due to its smaller importance.
So although the US economy is improving (see Stabilising the Cycle), the Fed has an excuse to delay raising interest rates if core PCE inflation remains subdued. This will support economic growth even further.
By contrast, the inflation-linked bond market, which prices off the CPI, should worry about the tightness of the housing market which should continue to boost this measure of inflation.
I told you it was hard, core!