Two sides to US inflation

Two divergent trends underpin US consumer price inflation, which remains below the Fed's target band. The service sector is trending upwards, but goods inflation remains particularly weak.

Inflation in the United States continues to track below the Federal Reserve’s target of 2 per cent. However, solid labour market conditions and a reduction in spare capacity should see core inflation measures trend up modestly over the year ahead. Nevertheless, the Fed will feel comfortable keeping rates low for the foreseeable future.

Consumer price inflation in the US rose by 0.1 per cent in line with expectations to be 1.6 per cent higher over the year. Though inflation has picked up modestly since July, it remains well contained and below the Federal Reserve’s annual target of 2 per cent.

Core inflation, which removes volatile items such as food and energy, also rose by 0.1 per cent and has slowed to be 1.6 per cent higher over the year. Food and beverage prices have climbed only 1.1 per cent since January 2013, while energy prices are up by 2.1 per cent.


Graph for Two sides to US inflation

One point worth emphasising is the divergence between inflation on goods and services. Services inflation rose by 2.4 per cent over the year to January and has gradually trended upwards over the past few years. By comparison, goods inflation has been particularly weak, fluctuating between periods of modest inflation and deflation.

The primary difference is exposure to trade. The services sector is primarily based upon domestic factors, whereas the goods sector is exposed to greater international competition and imported inputs. Most of the volatility in overall inflation is driven by trade-exposed sectors.

Consequently, I expect services inflation to continue trending upwards as the unemployment rate declines further. The general outlook for the US has improved significantly over the past six months – despite recent weather-attributed weakness – and this should result in greater wage pressures and rising inflation over 2014.

Goods inflation is a little tougher to forecast. The most important factor will be the US dollar, which is set to appreciate further if the Fed continues to taper its asset purchasing program. This would push import prices lower and put downward pressure on inflation. I also wouldn’t be surprised if commodity prices pushed lower as well.

On the other hand, rising growth prospects both in the US and internationally could put some upward pressure on prices and wages. Effectively the US would begin to import inflation from other countries.

Of those two effects the downward pressure from a higher US dollar should dominate. While wage growth could rise in the United Kingdom, there remains massive spare capacity in the eurozone and it will be years before we see significant wage pressures throughout Europe.

But goods deflation is not necessary a bad thing for the US or the broader inflation outlook. The US is more insular than most developed countries: trade as a share of GDP is much lower than it is in Australia or the eurozone, for example. Deflationary pressure in the goods market will have only a minor impact on measures of core inflation, while simultaneously raising the purchasing power of American incomes.

The Fed has signalled its determination to continue reducing its asset purchases when it next meets in March (Expect more talk but little rate action from the Fed, February 20). It is an indication that they are not particularly concerned about low inflation at the present time.

Based on current trends, a steady reduction in spare capacity across the country should result in core inflation measures trending upwards at a modest pace towards the Fed’s target band. Nevertheless, a fairly soft inflation outlook suggests that the Fed can keep rates low until they have completely unwound their asset purchases.