Core CPI (consumer inflation excluding food and energy products) reached 2.4% YoY growth in July, its fastest pace since 2008. In the US, the current backdrop of gradually rising prices makes perfect economic sense because the labor market is tightening, GDP growth is above-trend, and monetary policy remains accommodative due to the gradual pace of rate hikes in this cycle. So what’s next for core inflation over the coming months and years?
Core inflation is inertial and has historically operated with a fairly long lag to the real economy. For example, while the last recession officially ended in June 2009, core inflation did not reach a bottom until October 2010.
Within our toolkit for forecasting inflation, we have found that some of the best indicators operate using a 12-24 month lag. Keeping this in mind, we find that several of our preferred leading indicators imply that core inflation should continue to move higher. Parsing through regional and national surveys of business conditions, we find that there has been a clear and consistent trend across surveys that delays in shipments are growing, capacity constraints are building, and input costs are rising. In the chart below, this is illustrated by using a composite average that measures momentum of the regional surveys administered by the Federal Reserve banks.
The magnitude and timing of when producer capacity constraints actually passes through into overall consumer prices is not known with precision. That said, conducting a simple analysis over the past two decades that compares these survey results with changes in core CPI suggests that core inflation could rise 1.5% over the 2 year period from July 2017, when it was 1.7%, to July 2019. In other words, the probability that we could see a core CPI print over 3% in a year from now is rising.
Our conclusion that core inflation has further upside is corroborated by a separate monthly survey conducted by the National Federation of Independent Business, which asks small businesses a variety of questions about their expectations to spend, hire, invest, and change prices. The percentage of small businesses that expect to raise prices over the next 3 months has been steadily creeping higher since 2016, suggesting further upside to inflation over the coming years.
As the business cycle continues to mature, it will be important to keep these long lags in mind. Indeed, these subtle trends in the US economy may not seem so important today, but they could become the key headlines for inflation in the not-too-distant future.