BNY Mellon: Inflation, Fed Reinforce Each Other’s Messages

14 feb 2019

By John Velis, FX and Macro Strategist

• Price inflation remains under control
• Wage inflation showing some life but is not outpacing productivity growth
• Fed speakers in unison on pausing rate hikes

Today’s CPI release combined with a trio of Fed speakers (all of them non-voting members this year, but ranging from the hawkish Loretta Mester to the moderately dovish Raphael Bostic) confirm that we will not see rate hikes for a while - and maybe not at all this year unless something dramatic changes in the outlook.

January core inflation was up by a touch versus expectations at 2.2%, the same as it was in December. The Fed’s preferred measure of inflation, Core PCE has been delayed by the government shutdown; it won’t be until March 1 that we get the December data.

We have constructed a principal components-based measure of inflation pressures, combining nine different inflation series. The first principal component of these nine variables explains 82% of their co-movement – what we would call the underlying inflation process.

Data through December show inflation is no danger of breaking out, and remains below late-cycle levels that we have seen previously.

Underlying Inflation and CPI

SOURCE: BNY Mellon Calculations, Bloomberg

While market hawks might point to the concurrent release of average real wages, which have risen to just below 2% YOY, we don’t see that as a sign of overheating labor costs. It’s microeconomics 101: the marginal cost of labor (i.e. the change in wages) should equal the marginal contribution of labor (i.e. labor productivity growth).

While again – thanks to the shutdown – we don’t have 2018 Q4 productivity data, in Q3 it was 2.2%. If and when real wages exceed productivity growth, then we’d have a problem. At the moment, we do not.

Real Earnings Growth and Labor Productivity

SOURCE: Bloomberg

Today’s Fed speakers Mester, Bostic and Harker were all singing the same tune. “Wait and see” and similar phrases were clearly on the hymn sheet, along with sanguine messages on prices. It’s clear that the FOMC are all on the same page, and that page is open to “pause”.

It’s therefore illustrative to remind ourselves of a key line from Fed Chair Powell’s press conference after the January 30 FOMC in response to a journalist’s question: "We'll be looking at everything but I do think that … a big part of that would be inflation. It wouldn't be the only thing, but it would certainly be important."

The Fed cannot credibly prepare the ground for a rate hike while inflation remains around 2%. Fed pricing confirms this, with Jan19 Fed Funds pricing in a policy rate that is just a hair above the current target rate (2.40% versus 2.375% respectively).