Tuesday 18 July 2017 by Craig Swanger Opinion

What is happening to US inflation?

US inflation continues to surprise economists as it falters on the road back to 2% per annum. “Amazon Inflation” is part of the story, but not all of it – we look at what is happening and the implications

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US CPI increased at just 1.4% per annum to 30 June this year, or 1.7% per annum if we use the more relevant measure that excludes food and energy. Markets were expecting more and pushed the US dollar down as a result, due to expectations of lower interest rates in future. Inflation is the core driver of interest rates in times of moderate growth.

Two weeks ago we looked at “Amazon inflation”, the inflation rate of goods purchased predominantly online. We found that roughly 20% of the CPI basket in the Amazon Inflation Index was running at –1.2% per annum to the end of May, while the remaining 80% was growing at 2.1% per annum. June’s data showed Amazon inflation continued at the same deflating pace, while the balance of the basket fell to a growth rate of 2.0% per annum. 

The implication is that inflation across the board seems to be underperforming and the question of course is why.

US Fed Chair, Janet Yellen, said the Fed expects tight labour conditions to push inflation up to their target rate of 2% per annum. US labour conditions are much tighter than in Australia – its underemployment rate is back to its lowest point of the 2002-2007 growth phase, while Australia’s underemployment has been rising and is at levels not seen since the back end of the 1990s recession.

What does the data tell us?

Diving into the US inflation figures shows some price growth weakness forming over the past six months in particular.  Shelter (housing) is a major contributor to inflation and while it still grew at 2.8% in the past six months, its steep decline of almost 1% from 3.7% in the previous six months knocked 0.3% per annum off the overall CPI growth rate. As more housing supply comes to the market, rent and owner occupied costs are rising at a slower pace. This trend can be expected to continue in coming months. Car prices and medical care costs also dragged overall CPI – car prices fell 1.9% in the last six months alone. 

Why isn’t the tight labour market pushing up inflation?

Conventional wisdom tells us that when employment conditions are strong – meaning underemployment is low and participation rate is high – wages should rise.  Wages are responsible for around 60-70% of overall inflation, so there is a strong link between employment markets and inflation. 

Yellen and most other economists have expected inflation to rise as employment conditions tightened, but it hasn’t yet happened and in fact inflation seems to be weakening a little.  Excluding the items in the Amazon Inflation Index, inflation has fallen by 0.40% in the past year, despite underemployment falling from 10.4% to 8.9%. 

The explanation isn’t clear from the data itself, but there is a possible intuitive argument put forward in the Wall Street Journal and reprinted in the AFR last week.  The articles cited a “typical” US services business well outside the normal domain of Amazon and its online peers. The business was an Omaha roof repairs business, quoted as saying that they could not find US workers at the $17 per hour they were offering as the labour market was too tight.  However, they could not increase prices due to the digital economy method of sourcing household services via online price comparison sites.  The owner of the business said that when they had tried to increase prices, their business fell away steeply on these sites and, as most of their business was now sourced online, they had to drop prices again.

This is just one story, but it offers insight to how the rapid advance of online consumer search and spending patterns are impacting the broader economy. Discretionary spending is now 20% online, up from 17% last year. By 2030 this figure is estimated to exceed 50% as autonomous vehicles enable online shopping deliveries in under an hour for $1.00, compared to days or weeks in our current economy at $6.99 (using Amazon Prime’s pricing today and proposed pricing for future drone deliveries when they start later this year).  The more the digital economy instils itself into our lives, the greater the downward price pressure on everything, from books to roof repairs. Ultimately, this puts downward pressure on global inflation.

Near term outlook

Signs of wage growth in the US are stronger than Australia or Europe, but are still not meeting market expectations.  We suspect those expectations are based on outdated models that use the past to predict the future. In an age of rapidly changing technological impacts on costs and labour demand, this model will continue to overestimate future inflation and interest rates.  On that basis, we believe US inflation will remain below 2% per annum for the next year at least, but likely well beyond, despite its relatively healthy economy.  For the rest of the mature economies globally, the inflation outlook is even weaker.

For financial markets, this outlook implies long term interest rates will tend to overshoot then fall again as inflation disappoints, remaining in the 2.25% to 2.75% per annum range for US 10 year Treasuries. While weak in the US, inflation and interest rate growth will be weaker in Europe and Japan, and particularly in Australia, pushing the USD up against these other currencies.  

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