Headline and Core Inflation Are Converging

In August of 2016, we argued that although headline inflation was running at a 0.8% year-over-year pace, well under the Federal Reserve’s longer-term inflation goal, the tepid pace was the result of temporary factors that were likely to fade. At that time, declines in commodity prices over the previous two years and the lagged impact of currency appreciation were having an outsize effect on headline Consumer Price Index (CPI) inflation. However, underlying components (including shelter inflation) that are more sensitive to domestic fundamentals and labor market slack remained firm, supporting our expectation that headline inflation would rise to converge with our core inflation forecast of around 2.2%.

Yesterday’s CPI report bears out this view, with headline CPI inflation accelerating to 2.1% year-over-year in December from 1.7% in November, very close to the 2.2% year-over-year core inflation rate (see chart). As we expected, diminishing and more limited labor market slack has supported service inflation at a 3% annualized rate. And although the effects of the past dollar appreciation have taken a bit longer to fade due to a more recent bout of currency appreciation, the stabilization and recovery in energy prices has given its expected boost to headline inflation.

Focusing on the details of yesterday’s report, the 0.2% month-over-month advance in core inflation was in line with consensus expectations, but a touch firmer than we were expecting. Residual seasonality and heavy discounting during the holiday shopping season resulted in a decline in consumer-oriented core goods prices: Prices of apparel (-0.7%), furniture (-0.1%), recreation (-0.2%) and sporting goods (-0.2%) all fell in December. However, firming medical care categories after some weakness last month, stable shelter inflation and positive prints in the volatile hotels and airfares categories provided an offsetting boost.

TIPS breakevens may belie the inflation trajectory

It’s interesting that despite these trends, much of the Treasury Inflation-Protected Securities (TIPS) breakeven curve is still trading under 2%. Breakevens for TIPS maturing in two to five years are running between 1.7% and 1.9%, suggesting that market participants are still pricing in a relatively high probability that inflation will disappoint.

We believe the market may be getting this wrong. As we emphasized in a November 2016 piece, we think the stated policy agenda of U.S. President-elect Donald Trump and his incoming administration will shift the balance of risk toward higher inflationary outcomes. We view the expected launch of fiscal stimulus when we are already well into the latter half of the business cycle, coupled with a stated preference for trade restrictions, as a recipe for more inflation.

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Tiffany Wilding is a PIMCO economist focusing on the U.S. and is a frequent contributor to the PIMCO Blog.

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