"Recent sizable declines in oil prices will likely hold down overall inflation in the near term. But as the effects of these oil price declines and other transitory factors dissipate and as resource utilization continues to rise, the Committee expects inflation to move gradually back toward its objective."
- Janet Yellen, December 2014
"once oil and import prices stop falling, the downward pressure on domestic inflation from those sources should wane, and as the labor market strengthens further, inflation is expected to rise gradually to 2 percent over the medium term."
- Janet Yellen, February 2016
The Fed's Dilemma: The Wrong Kind of Inflation
- Inflation pressure does not come from economic demand (aka Resource Utilization)
Inflation comes from:
- Fed loose money policies (shelter aka real estate)
- Fiscal policies: Obamacare & minimum wage hikes
- Rate hikes can stem only part of the inflationary factors
- Fortunately, inflationary pressures continue to remain low
The Fed is Partially Right
- Oil price deflation is holding down inflation
- The effect is transitory
Oil inflation has been a major factor holding down inflation.
The Fed's timing is off a bit. Oil deflation is still working its way through the economy, courtesy of trucking. In the US, nearly 70% of all goods are shipped via truck, and shipping prices continue to fall. Because gas price surcharges are sticky downwards and lagging. Which means the effects will be around for most of this year.
But overall, the big impact has been felt.
The Fed is Mostly Wrong
- Economic demand is not about to drive up consumption-related inflation
- Inflation comes from areas largely immune to interest rate changes
- Inflation will remain mild
Problem #1: Resource Utilization is falling and set to keep falling
Per Yellen, the Fed expects resource utilization to rise. In fact, as measured by Manufacturing Capacity Utilization, resource consumption continues to drop: down for 15 months.
Go back to the trucking data. Prices dropped partly from oil price pass-thrus are partly due to a drop in demand. The load-to-truck ratio is at its lowest in 4 years (the ratio measures volume needing to be shipped relative to available trucks).
Contrary to Fed expectations, Resource utilization is not even close to rising.
Problem #2: Inflation from Fed's Real Estate-Propping Policies
The biggest source of inflation is shelter aka Real Estate. Real Estate inflation has been surging for years thanks to the Fed's specific policies aimed at boosted real estate property prices.
It's likely that recent tightening will slow this inflation.
The Fed created this part of the problem and is now, belatedly, addressing it.
But it also means that this source of inflation is poised to slow.
Problem #3: Obamacare Triggered Inflation
When I had my first baby, the doctor presented certain pre-natal tests. A few years later and with my 2nd baby on the way, the wonderful world of medicine had concocted a few more tests. All covered by insurance, naturally.
The reality in medical care is that, up and down the food chain, there is an incentive to spend more money. From the doctor's perspective, more tests means more money. And there's a cost avoidance element because of the very real threat of malpractice lawsuits if a 'standard' test was not performed.
And thanks to insurance coverage, firms are clearly motivated to develop new treatments.
Obamacare turbo-charged this behavior because it effectively wrote a blank check and created a new customer base. Nearly everyone and everything is covered. And cost containment has never been a part of Obamacare.
Which has meant inflation in healthcare.
And that's exactly what we see: medical care inflation was dropping until Obamacare started.
Guys like Martin Shrkeli can and do jack up prices easily in a system with maximal coverage and minimal cost containment.
This inflation is not sensitive to interest rates. And that's potentially where the Fed may miscalculate by misreading the inflationary signals and wanting to clamp down hard on an area that doesn't respond to interest rate hikes.
Problem #4: Slight Labor Inflation from Minimum Wage Hikes
Beginning in 2014, many cities and states began to hike minimum wages. Prior to that mandated hiking, many companies began to raise hourly wages anyway.
Laborers have no price power here: 7+ years into a recovery and unemployment in the leisure & hospitality sector is stuck at 7.7%.
But the stark reality of inflation reduced the disposable income of hourly wage earners. (The perverse irony being that we have fiscal policy in the form of minimum wage hikes trying to counter the inflation created by monetary policy in the form of rising rental costs thanks to surging real estate prices.)
Key point: wage pressure is emerging but for non-economic reasons.
* * *
Add it up
An overview of the components suggests the following for the next year
While we lose the deflationary impact of energy, we gain some deflation in food and the likely 2H disinflation in Shelter and services.
Within Core CPI, we should see falling inflationary pressure in the 2H if labor moderates and shelter inflation flattens.