lightning
Bank of Montreal report:
Warning! US Inflationary Pressures are Greater Than They Seem:
July 04, 1997
US inflation continued to surprise analysts in May, with the CPI falling to a 10-year low of 2.2% year-over-year from 2.9% in May
1996. As chart 1 shows, even excluding the volatile food and energy components, core inflation stood at 2.5% in May, down from
2.7% a year ago. This downward trend coincided with the unemployment rate breaking below 5.5% - a widely-believed inflation-safe
threshold. Several explanations have been provided for this stellar performance, including a lower inflation-safe unemployment rate,
moderate wage pressures, global competition, the strong US dollar and falling prices of high-tech products. (See for example, US
Inflation: How Long Can the Good News Last? BMO Economics Department, June 4, 1997.)
This analysis argues that there are two main factors behind the surprisingly tame US CPI: the past strengthening in the
US dollar and methodological improvements being introduced by the Bureau of Labor Statistics (BLS). Net of these two
influences, core inflation has been on an upward trend since the middle of 1996, precisely as predicted by standard
economic theory. In our view, there is little substance to suggestions that the non-accelerating inflation rate of
unemployment (NAIRU) has fallen significantly below 5 «%.
US DOLLAR
The US dollar has appreciated sharply from its low levels in early 1995. (Please refer to chart 2.) On a trade-weighted
basis, the dollar rose 14% between April 1995 and June this year. There are two channels through which a stronger currency
affects prices. One is the direct effect of lowering the price of imports and import-competing goods. The second is the effect of
discouraging exports and encouraging imports, which dampens growth in domestic production and thus tends to lead to lower
price pressures.
There is wide debate about the elasticity between changes in the US dollar and consumer prices, as well as about the length of
the transmission mechanism. For our analysis, we assumed conservatively that a 1% appreciation of the US dollar lowers
consumer prices by 0.1 percentage points over a two-year horizon. This suggests that if the 14% appreciation occurred over a
short period of time and the dollar stabilized thereafter, this would have a transitory effect of lowering inflation by 1.4 percentage
points. However, the appreciation was gradual and followed an equally marked depreciation. With currency movements affecting
inflation only with a lag, we estimate that the recent appreciation still had a negligible impact on inflation in late 1996. The
beneficial impact is more significant this year. Given our forecast of currencies of the US's large trading partners, including
Canada and Japan, the beneficial impact will peak at « percentage points late this year and in early 1998, to disappear by early
1999.
CPI IMPROVEMENTS
The Bureau of Labour Statistics is currently half way through a six-year program of methodological and technological
improvements in the consumer price index. (Briefing on the Consumer Price Index. Bureau of Labor Statistics, December 3,
1996) Since January 1995, the agency has been introducing changes to deal with a so-called "formula bias." This problem is
related to faulty procedures for sampling consumer spending patterns. It is believed that the improvements had permanently
lowered headline inflation by 0.2 - 0.3 percentage points by the end of 1996. More recently, the BLS has started to improve
the way it collects price information on medical procedures, shifting to costs based on patient bills from prices of individual inputs.
The new procedure better reflects the trend towards increased treatment on an out-patient basis, which is usually less costly than
treatment on an in-patient basis. This change could benefit inflation by up to 0.2 percentage points, although it is not clear whether
the impact will be permanent or temporary. The changes are just being introduced, hence we do not include this impact in our
analysis.
Moving forward, with the release of January 1998 data, the CPI weights will be updated to the 1993-95 benchmark period from the
1982-84 reference period. This updating will significantly reduce the so-called "substitution bias," whereby spending shifts towards
goods whose relative price is falling. The BLS has estimated that this will lower inflation by 0.1 to 0.2 percentage points.
UNDERLYING INFLATION IS TRENDING UP
When the impacts of the stronger US dollar and methodological changes are netted out, underlying core CPI (core 2) inflation
takes on a significantly different profile. Chart 3 indicates that instead of continuing to move down through the middle of 1996, the
underlying rate reverses its earlier downward trend and starts moving higher.
As can be seen from the chart below, changes in the US dollar affect both the level of and the trend in inflation. The core 1
measure, which adjusts the core CPI for currency movements, remains below the core CPI until January 1997, reflecting the
depreciation of the dollar through most of 1995. (See chart 2.) However, unlike headline inflation, core 1 inflation starts moving
higher in the middle of 1996, owing to a slower pace of depreciation of the US dollar through the second half of 1995. Since
February 1997, core 1 inflation continues to trend higher, rising above the headline figure. This is based on the rise in the US dollar
on a year-over-year basis through late 1995 and 1996. The methodological improvements to the CPI largely have a steady effect on
inflation, with the core 2 measure running above core 1.
Our conservative estimates suggest that underlying core inflation rose from 2.5% year-over-year in May 1996 to 3.0% in
May 1997. Importantly, underlying inflation started to trend higher when the unemployment rate dropped from 5.5% in
May to 5.3% in June 1996. The unemployment rate has subsequently moved lower, reaching a 24-year low of 4.8% in
May, which has coincided with the upward trend in underlying inflation. There is often a lag between the time when
the labour market becomes overly strained and when inflation rises. This suggests that the NAIRU is close to 5 «% or
even slightly higher, rather than around 5% as an analysis based on the headline inflation figures would lead one to
believe.
CONCLUSION AND IMPLICATIONS FOR FED POLICY
The downward trend in US headline inflation reflects the transitory impact of the stronger dollar and methodological
improvements. After the beneficial impacts of these two factors have run their course, the upward trend in underlying inflation will
show through in headline figures. With the unemployment rate anticipated to remain well below 5 «% over the next few quarters,
our analysis suggests that headline inflation will start accelerating in early 1998, once the beneficial impact of the stronger US
dollar passes through its peak.
Ideally, the Fed should focus on trends in underlying inflation. However, with headline inflation remaining tame, the Fed will
likely keep placing more emphasis on indicators of economic activity. Our forecast assumes that economic growth will
rebound strongly enough through the summer to prompt the Fed to hike rates by 50 basis points by the end of the year
in two steps, starting at the September 30 FOMC meeting. However, in our view, the tightening will take place too late
to prevent headline CPI inflation from picking up.
Wojciech Szadurski, Economist,
regards
gmweber |
