Nicholas J. Johnson, Mihir P. Worah
Inflation has been mostly dormant in the U.S. despite the Federal Reserve’s accommodative monetary policy, but it is likely to show signs of life this year. While slowly rising prices may seem desirable, prices that rise too slowly or even fall could have deleterious effects on the economy by incentivizing individuals and corporations to delay consumption and investment, and by making loans more expensive to service. Therefore, the Fed has renewed its focus on raising the inflation rate toward its 2.0% target for the Personal Consumption Expenditures (PCE) price index, which differs somewhat in composition and scope from the more widely recognized Consumer Price Index (CPI).
For 2014, we see CPI rising to 2.0% from 1.2% currently (and core CPI rising to over 2.0% from 1.7%; see Figure 1). We expect PCE, however, will remain below the Fed’s 2.0% target. Individuals will get some relief at the supermarket, but they will feel a pinch from landlords, who will likely raise rents.
What goes into our inflation forecast? When we model inflation over the cyclical horizon (six to 12 months), we quantify the lead/lag relationship between different variables and future moves in the subcomponents of inflation. For example, we find that changes in the price of a basket of grains like corn and wheat tend to lead food inflation by an average of eight months and have a beta of 0.07. This means that a 10% change in grain prices eight months ago leads to, on average, a 0.7% change in food prices at the grocery store today. The lag between something like raw food or materials prices and actual consumer inflation occurs mostly because there is a lag between increased input costs and how fast companies pass those costs down to the end consumer. There is also a lead/lag relationship between changes in the balance of supply and demand and changes in price. For example, when the vacancy rate falls in the housing market, we expect gradual upward pressure on the cost of rent. Similarly, these ideas are the basis for our models of other inflation subcomponents like new cars or home furnishings.
Shelter inflation is beginning to rise The cost of shelter is generally the largest component of an individual’s consumption, so modeling it correctly is an important part of getting the inflation forecast right. In the case of shelter inflation, variables like home prices, mortgage payments and vacancy rates tend to lead realized shelter inflation by 8 to 12 months. All of these relationships have an economic rationale for leading changes in the pace of shelter inflation. The vacancy rate speaks to the tightness in the rental market, while the levels of home prices and mortgage rates speak to the tradeoff between buying versus renting. All else equal, lower vacancy rates and a higher cost of home ownership should lead to higher rental prices, but all of this takes time, and the rate of shelter inflation increases with a lag.
Given the timing of the rise in home prices in 2012 and the increase in mortgage rates this year, the upward pressure on shelter inflation is just starting. In our inflation outlook last year, we wrote, “While it is true that lower vacancy rates and an improving housing market are providing upward pressure to rental inflation, housing prices didn’t really bottom until Q2 2012, which means we don’t see that pressure materializing until near the end of 2013.” And that is exactly what is happening now. In the CPI print for November, shelter inflation increased by 0.3% month over month, the highest monthly rate of increase since 2008. We expect shelter inflation to continue to accelerate, ultimately approaching 3% on a year-over-year (YoY) basis by the end of 2014 (see Figure 2). This acceleration is very important for forming expectations about the CPI, since shelter, at 32%, is the largest component of the CPI.
Food and energy inflation have declined Food and energy have been notable disinflationary influences recently. Over the past year, food inflation has declined on the back of falling corn and other agricultural prices. The decrease in grain prices was driven by a sharp increase in the size of U.S. crops following three years of drought. Now that prices of corn and other agricultural products have normalized, the risk of further price declines is limited. Gasoline inflation has also fallen over the past year, primarily driven by growing U.S. oil production and a lack of further geopolitically related supply disruptions.
Oil prices are very volatile from year to year, and future changes are always difficult to assess, but our base case is that they are likely to be relatively stable and average between $105 and $110 per barrel, with greater oil demand due to a growing economy offset by increased supply from North America and some incremental return of production from Iran and Libya. Oil prices remain the main uncertainty to our 2014 inflation forecast. The risks are increased disruptions in Nigerian production or a flare-up of violence in the Middle East resulting in higher prices, or on the constructive side, faster than expected progress toward an agreement with Iran, resulting in lower prices (see Figure 3, which shows the potential impact of such events on our forecast for headline CPI).
An additional disinflationary factor over 2013 was the stronger dollar and relatively low Chinese inflation, which tends to lead inflation of imported U.S. goods. However, the tightening U.S. labor market and the recent strengthening of Chinese CPI over the past several months should provide modest upward pressure to core CPI excluding shelter.
The PCE versus the CPI What are the implications for the PCE, the measure of inflation the Fed targets? The CPI and PCE are similar and tend to track each other closely, but they can diverge due to subtle methodological differences. In fact, right now core CPI is running at 1.7% YoY versus just 1.1% YoY for core PCE.
A main difference between the PCE and the CPI is their weights. The PCE has roughly a 15% weight to shelter, compared with over 30% for the CPI. Given our view that shelter will be one of the main areas of strength for inflation this year, we expect the PCE to continue to average well below the CPI. Offsetting the lower shelter weight in PCE is a higher weight to medical inflation. The rate of medical inflation recently has been declining, which we expect to continue this year, keeping the spread between the PCE and CPI wide relative to historical standards. Thus, although we expect PCE to rise, we think it will end 2014 still well below the Fed’s 2.0% target.
Key points for 2014 Adding it all up, we expect core CPI to increase to 2.1% by the end of 2014. With our base case oil forecast in the $105–$110 per-barrel range and expectations for food prices to be stable, this puts our headline CPI forecast around 2.0% YoY this year. Even though we believe inflation will increase over the next year, we expect PCE will likely remain below the Fed’s 2% target, around 1.5%. While the Fed must balance many different objectives, we do not see the inflation outlook as putting pressure on the Fed’s governors to tighten their policy stance.
We expect consumers will find that the pace of rental inflation is increasing. Food and gasoline prices will be relatively stable. Medical and education costs continue to grow, albeit at a slower pace than in recent years. Automotive prices are likely to be relatively stable, as will the price of imported consumer goods. And airfares are likely to be relatively steady after increasing strongly over the past year.
So what are the investment implications of our forecast? The Treasury Inflation-Protected Securities (TIPS) market is implying CPI inflation of only 1.4% over the next year, as opposed to our expectation of 2.0%. Therefore, we believe TIPS are likely to be an attractive investment for 2014.
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