Inflation data has taken on more importance recently than at any other time since the global financial crisis. And the narratives about U.S. inflation – or
the lack of it – have been hotly debated.
On the reflation side of the argument, you have the Federal Reserve Open Market Committee (FOMC). The FOMC has said that current low realized inflation is
mostly due to an oil supply shock that is good for both the consumer and the U.S. economy. According to the Fed’s line of thinking, U.S. interest rates are
low largely because of increased demand for nominal Treasuries, which has reduced their risk premia. While the “inflation compensation” that can be derived
from Treasury Inflation-Protected Securities (TIPS) has moved lower, that could be the result of demand for nominal Treasuries alongside rising liquidity
premia in less-liquid TIPS. Supporting this theory are survey-based measures of long-term inflation expectations, which are little changed despite current
inflation running below the Fed’s 2% target. Finally, the Fed believes that the U.S. will have higher inflation over the medium-term horizon due to the
ongoing strengthening of the labor market and closing of the output gap.
On the disinflation side of the argument, you have the markets. Investors in global fixed income markets seem to be interpreting lower oil prices as due,
at least in part, to weaker oil demand and a weakening global economy. In their view, low U.S. nominal interest rates reflect that economic weakness, and
low inflation expectations are a result of premature hawkishness from the FOMC, which stands ready to raise interest rates as early as mid-2015. Current
market pricing of U.S. Treasuries assumes secular deflationary forces – like demographics, deleveraging and globalization – will keep inflation at bay for
a long time.
So who is right, the markets or the Fed? The right answer will be key to investment returns in 2015.
A closer look at inflation dynamics
While headline inflation softened in 2014, core measures of U.S. inflation ended the year about where they started. The Consumer Price Index (CPI)
increased by 0.8% year-over-year versus 1.5% in 2013, reflecting lower energy prices. However, the core CPI, which excludes volatile components such as
food and energy prices, increased by 1.6%, similar to its 1.7% increase in 2013. The Personal Consumption Expenditures (PCE) price index rose 0.7% versus
1.2% a year ago, and the core PCE – the index most closely followed by the Fed to drive monetary policy – remained steady at 1.3% from year-end 2013 to
The main driver for headline inflation in 2015 will likely be the 50% drop in oil prices. With gasoline accounting for 4.5% of the CPI, we expect headline
CPI to print negative on a year-over-year basis for most of the year. Market-based measures of inflation are also anticipating this: The TIPS market
implies negative headline year-on-year inflation for most of 2015.
But while the drop in headline inflation is pretty much “baked in” and already accounted for by the markets, the key question is whether core inflation
will decelerate as well. While the Federal Reserve may look through energy volatility to set the timing of their first hike, changes in core inflation
(either weaker or stronger) will likely factor heavily into monetary policy decisions.
So what do we expect for core U.S. inflation over the cyclical horizon? Higher shelter costs were the main contributors in 2014, something we anticipated
(see the Viewpoint, “U.S. Inflation Outlook 2014: Signs of Life”). We expect shelter costs to rise by 3% in 2015, driven by the lagged impact of
higher home prices and a low vacancy rate. This will contribute to continued strength in services CPI, which increased at 2.5% in 2014, indicating a robust
domestic economy. Meanwhile, consumer goods prices surprised us by declining in 2014 (we had expected a marginally positive contribution), though we expect
reversion of some of that weakness. Taking all these factors into account, our bottom-up inflation model would point at 2% U.S. core CPI for 2015 (see
However, key top-down macro issues will also factor into our forecast for core CPI this year. These are the pass-through from weak energy prices into core
prices, the impact of a stronger dollar and the effects of an incrementally tight U.S. labor market.
How will lower oil prices affect core inflation?
One way to quantify the potential pass-through of negative headline inflation into core inflation is a simple regression analysis of core CPI against the
gap between headline and core CPI with a six-month lag. This regression shows a beta of 0.2 over the past 20 years, so if headline CPI runs at −0.5%
against a core CPI trending at 2%, the model implies a 0.5% drag on core CPI, which would move our original core forecast from 2% down to 1.5%.
But we believe this naïve regression overstates the inflation pass-through because changes in energy prices have often been driven by general economic
conditions over the last 20 years (for example, during the global financial crisis). This time around, however, we attribute the drop in energy prices to a
welcome improvement in supply capacity. Accounting for this broader economic context by adding income, unemployment and other indicators to the regression
analysis reduces the pass-through of lower energy prices to core CPI to 0.15%, which would reduce our original bottom-up forecast of 2015 core CPI to
1.85%. But we still need to consider how to incorporate other top-down factors.
What about a stronger dollar?
The deflationary shock of 2008 has been the hot potato that central bankers have been passing around through weaker currencies. One can easily link lower
consumer goods prices with the stronger dollar – the tradable sector should be the most sensitive to changes in the currency, and dollar strength may
explain some of the weakness in core goods inflation in 2014. But historically, the correlation between the dollar and inflation has been close to 0,
probably because a stronger dollar typically came alongside a stronger economy. Lower goods inflation means more money in the pockets of consumers, who
could then spend that money on services like shelter and healthcare, two areas where we expect continued inflation strength. The net contribution of the
dollar’s outlook to our U.S. core CPI forecast is marginal.
And the stronger labor market?
Unlike weaker energy prices and the stronger dollar, the strengthening U.S. labor market contributes positively to our core CPI outlook. Employer and
worker surveys both indicate expectations of higher wages in 2015, and we think that the Employment Cost Index (ECI) – our preferred gauge of wage
inflation – will move from its current 2.2% to closer to 3% by the end of 2015 (see Figure 2). The fast pace of declines in unemployment measures supports
the view that wage inflation should pick up over the cyclical horizon. We estimate that a 1% increase in personal income contributes 0.14% to core CPI with
a 12-month lag. But due to the lag, the impact of higher wages should be only partially realized in 2015.
The Fed has said it may begin policy normalization with core inflation near current levels, but it “would want to be reasonably confident that inflation
will move back toward 2% over time.” Higher wages could give it that confidence. Given our view on wages, the Fed could begin to raise rates in mid-2015,
but keep in mind that Fed policy will still be very accommodative in the early stages of the tightening cycle, and we expect the pace of hikes to be slow.
In the case that wage inflation remains sluggish, the Fed would almost certainly err on the side of caution, perhaps by delaying the first hike or slowing
the pace of tightening.
Putting it all together
After gathering all these bottom-up and top-down views, we expect core U.S. inflation (as measured by CPI) to come in somewhere between 1.75% and 2% in
2015, a modest uptick from 2014. And so to answer the question we posed earlier – “Who is right, the markets or the Fed?” – we would say that we tend to
side with the Fed. Transitory forces like lower energy prices and a stronger dollar are keeping inflation below target at the moment, but lower energy
prices are ultimately good for the consumer, and we anticipate wage inflation picking up over the cyclical horizon.
To its credit, the Fed has been more right than wrong on inflation since the global financial crisis. For most of the past six years, market commentary has
centered on how the Fed’s extraordinary monetary policy would fuel higher inflation. And yet, as the Fed stands poised to remove some of that extraordinary
accommodation, a new wave of bond market vigilantes are testing their deflation-fighting credibility! However, it isn’t clear to us whether these Treasury
bond buyers are truly deflation vigilantes – they may simply be yield-starved investors or portfolio hedgers.
We’ll find out the answers to these questions throughout 2015, which should be an exciting year for the inflation markets. Indeed, current valuations in
the TIPS market price 10-year inflation expectations at 1.70% (see Figure 3), compared with the Fed’s inflation target of 2%. If you believe in the Fed’s
ability to create inflation, this means that bond investors are currently being paid to hold inflation risk rather than insure themselves against it –
contrary to historical norms. These valuation dynamics, along with our outlook for a modest rise in core inflation, lead us to prefer holding U.S. interest
rate duration in inflation-protected form. As a result, a TIPS overweight is one of our highest-conviction positions across many PIMCO portfolios.