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Explaining the unusually low U.S. Inflation rate

Image source: WSJ

Over the past year, as the U.S. economy has been growing at a steady pace with unemployment approaching the 4% threshold, low inflation is threatening the plans of the Federal Reserve to pursue a rate hike in December. On October 6th 2017, the U.S. Department of Labor unveiled the September Job Report containing data on the American labor market for the past month.

The unemployment rate is at its lowest level since 2001. In September the unemployment rate dropped to 4.2% and has been below 4.5% for more than 6 months (the Fed considers 4.5% as the acceptable threshold in the long run). Since the beginning of 2017, on average, 148,000 jobs have been created every month, a lower figure than last year’s (187,000) but still a reminder of the overall health of the US economy.

(Source: U.S. Bureau of Labor Statistics)

Wage growth, however shows little evidence of improvement. Salaries in the private sector rose 2.9% over the past year. Since the end of 2015, wages were increasing at a modest rate of 2.5% year on year, with inflation at around 1.6%. Real wage growth was limited to 1%. While it is certainly greater than at the start of this economic cycle, it remains slow by historical standards. Janet Yellen, chairwoman of the Federal Reserve, declared on the 15th of October that the pace of wage growth seemed “broadly consistent with a tightening labor market once we account for the disappointing productivity growth in recent years”.

(Source: The WSJ)

Core inflation remains below 2%. The CPI-U (Consumer Price Index for All Urban Consumers: All Items), is a measure of the average monthly change in the price of goods and services paid by urban consumers between two periods. The CPI can be used to recognize periods of inflation and deflation. However, given that the CPI includes volatile prices for food and energy, it may not be a reliable measure of inflationary and deflationary periods. For more accurate detection, the core CPI excluding prices of food and energy (Consumer Price Index for All Urban Consumers: All Items Less Food and Energy) is often used.

(Source: US Bureau of Labor Statistics)

In September, the Consumer Price Index for All Urban Consumers (CPI-U) for all items was up 2.2% year-on-year. This increase is mainly due to the sharp rise in the energy index (+10.1% year-on-year). The food index has increased by only 1.2% over the last 12 months. The index for All Items Less Food and Energy (core CPI) increased 1.7 % for the 12 months ending September. The 12 months change is accelerating as it was only 1.6% in June.

Fed plans to keep raising rates. Even if an acceleration in personal consumption expenditure seems to be emerging, core inflation is well below the 2% target. It has been five years since core inflation last exceeded the 3% threshold. However, members of the Fed's monetary committee are likely to give more weight to the recent unemployment figures and the rebound in GDP growth and maintain their objective of gradual normalization of monetary policy.

Referring to the Fed's benchmark rate, Ms. Yellen said, “We continue to expect that the ongoing strength of the economy will warrant gradual increases in that rate to sustain a healthy labor market and stabilize inflation around our 2 percent longer-run objective.”

The Fed has already raised twice its rates this year but kept them in the range of 1% to 1.25% at its last meeting in mid-July. Investors expect a third 0.25 percentage point increase at the Fed's final policy-making meeting of the year, in mid-December.

The inverse relationship between unemployment and inflation cannot be observed in the American economy. Yet the theory, and in particular the Phillips curve, shows that the lower the unemployment rate, the higher the rate of inflation. Several hypotheses can explain the low inflation despite the recovery of employment. The Fed explained at the middle of the year the absence of inflation by a series of non-structural, coincidental factors such as lower wireless data charges or lower drug prices. Mid-October Mrs. Yellen said that "(her) best guess is that these readings will not persist" adding that inflation should increase as growth continues”.

Unlike the Fed, other economists see structural phenomenons as the cause of the sluggish inflation in the United States. A popular thesis developed last year by David Trainer in Forbes stated that competition of online disruptors led to a decline in prices in the overall economy. The ability to compare prices and to have access to greater information on virtually any good or services has changed the pricing power of firms and brand loyalty among customers. Moreover, technological innovations have been putting pressure on wage growth, especially on low-end labor. Finally, if the “Amazonification” of the economy proves to be true, monetary policy in the United States would be altered as inflation would no longer be in the Fed’s hands. However, this theory has come under wide criticism as different analysts have questioned the exact impact e-commerce has had on the US economy. As recounted by Sam Fleming in the Financial Times, Goldman Sachs analysts showed that the pricing power of US-based companies has consistently increased over the last two decades while estimating at a relatively small 8% the proportion of e-commerce sales among overall retail sales. Other analysts at BCA Research challenged the Amazonification theory by looking at Amazon’s financials. Their analysis showed that Amazon’s growth is mostly funded by share price appreciation and that its cash flows have not seemed to be growing sufficiently to make the company responsible for any supply shock.

Global forces may also be responsible for the stagnation of inflation. A study released by the IMF in September found that in a given country, what may have a negative impact on wage growth in another domestic economy is so-called "labour slack". This concept indicates a is a situation in which the excess supply of labor is beyond the amount that firms would like to employ. In this regard, Janet Yellen admitted that the entrance of China in the global market may have negatively impacted growth in the US.

As the low inflation dilemma continues to challenge classic monetary policy theory, the new chair of the Fed is expected to be announced later this week by Donald Trump. Mrs. Yellen’s successor, Jerome H. Powell, will have to contend with this conundrum: are we in a permanently low inflation environment or has the pickup in inflation just been delayed? Janet Yellen seems to believe in the latter theory and soon, we will find out whether her successor will think the same.




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