July Quick Read on the US Economy

The economic news improved somewhat from my last update.  The labor market looks more solid than it did a month ago and there are some signs the manufacturing sector may have found it footing.  I believe the Brexit vote will likely have only a modest direct impact on the US, but will make all observers less confident of their predictions for global growth.  This summer, the fed may try to convince the market that it will hike again in September, but my guess is that the December will be the earliest.

 

Our latest reading for the Astor Economic Index® (“AEI”) is higher than last month, and at near the highest level posted this year.  I still see the US as currently growing above average. The AEI is a proprietary index that evaluates selected employment and output trends in an effort to gauge the current pace of US economic growth.

Source: Astor calculations

The labor market has been doing its noisy best to upset the stomachs of economists.  June’s payroll number showed a solid recovery from the weak numbers posted for April and May.  That being said, smoothing the series somewhat by looking at year over year percentage change shows that the US economy is still adding jobs but at a somewhat slower pace than has prevailed over the last few years.

The nowcasts produced by the Federal Reserve banks of Atlanta and New York are both still showing stronger growth in the second quarter than the first.  The Atlanta Fed is currently estimating 2.3 SAAR and the New York Fed 2.1.  These are both slightly weaker than last month’s estimate.  Both have been updated since the employment report.

 

The biggest economic surprise of the year has been the vote for the UK to leave the European Union.  At Astor, we were pleased to provide rapid reaction to this event on our blog on the morning and afternoon of the vote.  I think our analysis holds up well: see CEO Rob Stein’s take here and mine here.   As some of the dust has settled, short term implications for the UK economy are seen as dramatic by many economists.  For example, the panel of economists surveyed by Consensus Economics is now forecasting 1.1% growth in 2017, down from a 2.1% forecast last month.  Reductions for growth in the Eurozone are smaller.  Consensus Economics now forecasts 1.4% in 2017 down from 1.6%.  These same economists are not currently seeing significant direct effects on the US or the rest of the world.  The swift resolution of the UK leadership contest (with a new Prime Minister this week as opposed to the September time table originally announced) may offer grounds for optimism that a deal may cut short the period of uncertainty.

 

I see Brexit uncertainly leading to reduced investment by both firms and households as the primary channel affecting UK GDP.  To the to the extent that the uncertainly will have sustained spillovers into the financial markets it could have indirect effects on the US.  For example, the dollar initially rallied after the vote, but is now about the level that obtained in early June.  Should the dollar appreciate against our trading partners, it would be expected to make exporting more difficult.  In my opinion, the largest effect, however, seems to be in government bond yields.  US ten year yields have moved down 25 basis points to a yield of around 1.50% as this note is being written.  While, some of this may be safe haven demand that one can hope will be reversed as a path forward emerges, there are few of the other typical signs of investor fear.  Investors willing to take 1.5% for 10 years may be foreseeing long spell of a worrying lack of attractive opportunities for investment in the US and abroad.

 

When last we heard from the fed, their rate-raising plans were put on hold by the poor payroll numbers in April and May.  Does the decent report for June portend another hiking scare?  I think it is too soon to tell.  My interpretation of their speeches is that for the fed to raise rates they need to be convinced that the labor market is at full employment and that inflation will return to target in the medium term.  The last report has some points for both sides.  If the decision was finely balanced before, then in my opinion the Brexit vote strengthened the doves’ position.  Neither inflation nor the labor market are likely to see a boost because of it, and I imagine the decline in yields has the fed’s attention.  My guess is that a few hawks will try to make the case for a hike over the summer but that the fed will not hike before December.  For what it’s worth, the most common interpretation of rates implied by fed fund futures market sees only a small chance of a hike before the end of the year, as opposed to the situation in January when more than one additional hike was priced in.  A sustained return to the relatively robust labor market we saw over 2014-2015 would increase the likelihood of a hike.

 

Overall, I am relieved the labor market seems to have bounced back from a weak April and May, but I will feel better about the economy if we see this strength confirmed over the next few months.

 

 

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information.

 

“The Astor Economic Index® is a proprietary index created by Astor Investment Management LLC. It represents an aggregation of various economic data points: including output and employment indicators. The Astor Economic Index® is designed to track the varying levels of growth within the U.S. economy by analyzing current trends against historical data. The Astor Economic Index® is not an investable product. When investing, there are multiple factors to consider. The Astor Economic Index® should not be used as the sole determining factor for your investment decisions. The Index is based on retroactive data points and may be subject to hindsight bias. There is no guarantee the Index will produce the same results in the future. The Astor Economic Index® is a tool created and used by Astor. All conclusions are those of Astor and are subject to change.”

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June Quick Read on the US Economy

The economic news softened somewhat from my last update.  The payroll numbers for May were especially weak, following a modest April.  However, we should not exaggerate one reading of a volatile series Overall the economy still looks like it is on a decent heading, but evidence has accumulated of at least a small pause in growth.  This is likely to make the FOMC  put off rake hikes.

 

Our Astor Economic Index® (“AEI”) shows growth is lower than last month, though slightly above this year’s lows posted in February.  However, I still see the US as growing above average today. The AEI is a proprietary index that evaluates selected employment and output trends in an effort to gauge the current pace of US economic growth.

usei.png

Source: Astor calculations

 

In remarks made on June 6th, Federal Reserve Chair Janet Yellen called the May jobs report “disappointing and concerning”  but she still believed that the fundamentals of the economy are strong.  I tend to agree with the Chairman.  How weak was the jobs report?  In the chart below, I averaged the last three month’s increase in payrolls to smooth out the numbers.    As a result, the increase in payrolls has dropped to an average of 116,000 jobs over the last March-May period.  For most periods since 2012, the increase in payrolls has been in the 175,000-250,000 range, though it has printed this low a few times.  At this stage in the recovery, the s that it will take only 70,000-90,000 jobs a month to keep the unemployment rate stable.  In my opinion the current jobs  report is poor but we need to see additional signs of weakening before we move from concerned to alarmed.

 

payroll.png

Source:Bureau of Labor Statistics

 

It is not just Astor Investment Management who is still seeing the growth picture as somewhat positive.  The nowcasts maintained by the Federal Reserve Banks of Atlanta and New York both show stronger growth than the first quarter.  The Federal Reserve Bank of Atlanta is currently estimating 2.5% and the Federal Reserve Bank of New York is estimating 2.4%.  Both have been updated since the employment report.

 

Where does this leave the Federal Reserve?  The market no longer believes that the June meeting is a real possibility for a rate hike anymore.  I agree.  In Ms. Yellen’s speech, mentioned above, she gave cases both for and against another hike.  The main case for hiking rates is that as long as inflation is expected to return to its target of 2%, in the medium term the Federal Reserve should soon raise rates slightly, so as not to have to raise them a lot later.  The case against another hike is that there is probably still additional labor market slack beyond the 4.7% unemployment rate and that inflation has spent very little time above what is supposed to be a symmetric target in the last ten years.  In addition, the inflation expectations seem to be drifting down slightly, something Ms. Yellen said she will be watching closely.

 

Should the payroll weakness continue or inflation expectations drift down further, rate hikes would likely be off the table.  If, on the other hand, those indicators show renewed signs of a strong economy then the Federal Reserve may finally make the second hike.  Will the election delay things?  The Federal Reserve wants to be seen as divorced from the political scene. The Federal Reserve moved rates in the summer or early fall in 3 of the last 6 presidential elections, not including the crisis year of 2008.  September 21st is another press conference FOMC so expect speculation to be attracted to that meeting, assuming no dramatic surprises in the economy.

 

Overall, I am concerned about the state of the economy and while I expect the last, weak payroll to be an aberration, I will be watching the numbers with more than usual interest next month.

 

 

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. The investment return and principal value of an investment will fluctuate and an investor’s equity, when liquidated, may be worth more or less than the original cost.


The Astor Economic Index® is a proprietary index created by Astor Investment Management LLC. It represents an aggregation of various economic data points: including output and employment indicators. The Astor Economic Index® is designed to track the varying levels of growth within the U.S. economy by analyzing current trends against historical data. The Astor Economic Index® is not an investable product. When investing, there are multiple factors to consider. The Astor Economic Index® should not be used as the sole determining factor for your investment decisions. The Index is based on retroactive data points and may be subject to hindsight bias. There is no guarantee the Index will produce the same results in the future. The Astor Economic Index® is a tool created and used by Astor. All conclusions are those of Astor and are subject to change.

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May Quick Read on the US Economy

Economic news softened somewhat from my last update.  The most recent readings for employment (as measured by the non-farm payrolls report) showed a slightly weaker pace of growth.  Additionally, much of the bounce in the Institute for Supply Management’s Manufacturing Index was given back last month.  However, we should not exaggerate the weakness.  The current situation in the US economy seems to be self-sustaining demand in the US but with ongoing weak international growth.

 

Our Astor Economic Index® (“AEI”) shows growth levels marginally above the recent lows posted in February, though a bit weaker than a month ago.  The AEI is a proprietary index that evaluates selected employment and output trends in an effort to gauge the current pace of US economic growth.  The chart below shows the last few years of this gauge which has been in a trendless range over that period.usei

The GDP print at 0.5% for the first quarter was weak.  We trailed this possibility last month based on predictions from the nowcasting models published by the Federal Reserve Banks of New York and Atlanta.  These models, with very little live data, are currently showing only modest improvement in the second quarter, about 0.8% at an annual rate.

 

The headwinds from abroad continue.  The chart  below shows the year-over-year percentage change in the volume of world industrial production (as calculated by the CPB Netherlands Bureau for Economic Policy Analysis).  That is, this index is supposed to ignore currency changes so it should be a bit more steady than market prices.  The deterioration in the last few years is obvious but, as of now, has avoided the unremitting declines associated with the 2001 and 2008 recessions and is still showing that world industrial production is increasing year on year.  However, stagnant growth combined with the strong dollar makes for an external environment unlikely to boost growth this quarter.

world.prod.cng

The lack of follow-through from the previous month may make it difficult for the Fed to raise rates again at their June meeting, but expect speeches from FOMC members to try to keep the dream of hiking alive.  However, the market is having none of it as Fed Funds futures are currently forecasting no change in June.

Overall I expect more of the same positive but tepid growth in the weeks ahead.

 

 

 

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. The investment return and principal value of an investment will fluctuate and an investor’s equity, when liquidated, may be worth more or less than the original cost.


The Astor Economic Index® is a proprietary index created by Astor Investment Management LLC. It represents an aggregation of various economic data points: including output and employment indicators. The Astor Economic Index® is designed to track the varying levels of growth within the U.S. economy by analyzing current trends against historical data. The Astor Economic Index® is not an investable product. When investing, there are multiple factors to consider. The Astor Economic Index® should not be used as the sole determining factor for your investment decisions. The Index is based on retroactive data points and may be subject to hindsight bias. There is no guarantee the Index will produce the same results in the future. The Astor Economic Index® is a tool created and used by Astor. All conclusions are those of Astor and are subject to change.

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April Quick Read on the US Economy

The latest numbers on the US economy were positive. As a promising sign for the future, the global manufacturing environment may be showing signs of stabilizing – coincident with a stabilizing of commodity and international equities prices. I still believe the Fed will continue to hold and will not raise rates in April.

Our Astor Economic Index® (“AEI”) shows growth somewhat above the recent average and stronger than last month. The AEI is a proprietary index that evaluates selected employment and output trends in an effort to gauge the current pace of US economic growth.

Source: Astor calculations

Source: Astor calculations

The employment report (nonfarm payrolls) for March was broadly positive. The number of new jobs was again quite close to its two-year average. We can see no sign of broad based weakness in the economy within the payroll numbers. The tick up in the unemployment number was welcome as it represents more people looking for work who were previously on the sidelines of the labor market. The prime age employment-population ratio has improved markedly in the last quarter, though it is still lower than the previous expansion.

Despite this good news on the employment front, the preliminary release for GDP for the first quarter of 2016 – due at the end of April – is likely to be weak. The chart below shows the Atlanta Fed’s current estimate of first quarter GDP calculated via their GDP Now methodology. The weakness – if it materializes in the final numbers – can partially be put down to a higher trade deficit and an inventory drawdown both of which can be transitory. Weaker consumer expenditures is more concerning.
It is also worth noting the BEA is considering a secondary seasonal adjustment to try and account for the pattern of unusually weak first quarters which economic observers have been subjected to over the last few years.

The Atlanta Fed's GDP Now

The Atlanta Fed’s GDP Now

For several months we have been highlighting the weak international manufacturing environment. This weakness is most easily seen in the chart below of global manufacturing purchasing managers indexes. which have shown sharp deterioration over the last year. The latest numbers show a bit of an improvement so perhaps we can be hopeful, though careful readers will recall similar optimism in February’s read. If this bounce continues, it is possible that some of the external weakness in the US will begin to be reversed.

Source: Markit, NAPM, Bloomberg, Astor Calculations

Source: Markit, NAPM, Bloomberg, Astor Calculations

The Federal Reserve chose not to raise rates in March and statements since lead me to believe the hawks on the committee have become somewhat convinced the prospect of a weaker economy poses a greater danger than the specter of run-away inflation. The official stance is the FOMC wants to be convinced inflation is heading back to its target – somewhat above current levels. I would expect the reversal of recent trends in the dollar and crude oil prices will both tend to move inflation higher in coming months. The latest data we have shows the Fed still sees an additional two to three hikes in 2016, while the market predicts about one.

In short: The evidence today suggests to me the US continues another month of positive if somewhat tepid growth.

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. The investment return and principal value of an investment will fluctuate and an investor’s equity, when liquidated, may be worth more or less than the original cost.
The Astor Economic Index® is a proprietary index created by Astor Investment Management LLC. It represents an aggregation of various economic data points: including output and employment indicators. The Astor Economic Index® is designed to track the varying levels of growth within the U.S. economy by analyzing current trends against historical data. The Astor Economic Index® is not an investable product. When investing, there are multiple factors to consider. The Astor Economic Index® should not be used as the sole determining factor for your investment decisions. The Index is based on retroactive data points and may be subject to hindsight bias. There is no guarantee the Index will produce the same results in the future. The Astor Economic Index® is a tool created and used by Astor. All conclusions are those of Astor and are subject to change.

304161-388

March Quick Read on the US Economy

In my opinion, the latest numbers on the US economy were positive last month. After plummeting for the first half of February, stock markets became markedly more positive over the second half. International equity prices seem to have regained their footing and oil prices are well off the lows of the year as well. I still see the global growth environment as tepid: with the US being the main bright spot. Despite the international headwinds, I expect the Fed to begin to signal it will continue to tighten according to plan.

Domestic highlights in February

Our Astor Economic Index® (“AEI”) shows growth somewhat above the recent average and slightly stronger than last month. The AEI is a proprietary index that evaluates selected employment and output trends in an effort to gauge the current pace of US economic growth.

I saw the employment report (nonfarm payrolls) for February as broadly positive. The number of new jobs was almost exactly at its two year average. I see no sign of broad based weakness in the economy when viewing the payroll numbers. Readers who want to burnish the negative case may have to dive into the weekly aggregate payroll. This number takes the number of employees and multiplies by the hours per week and again by dollars per hour. The result is something like a weekly wage bill and it posted a rare down month in February as hourly earnings and hours worked both posted modest declines.

In short: I think the pessimism in the first two months of the year were driven by fearful projections rather than data and that current views of the state of US economy are more realistic.

International environment

Last month, I was hoping for signs of strength in the world manufacturing cycle. It seems as if my hopes will have to wait at least until spring. While the Institute for Supply Management’s Manufacturing Index for the US showed a modest (but welcome!) bounce for the month, the picture in the rest of the world was not so rosy. The chart below weighs PMIs in roughly the G-20 countries, each one weighed by their GDP. This measure is looking for new low since 2012.

 

world.pmis.2016-03-04.png

Source: Institute for Supply Management, Markit, Astor calculations

The Fed

I believe the next red-letter day for the market should be FOMC Chair Yellen’s post meeting press conference on March 16th. Few expect the Fed to raise rates but many will be placing bets on the nature of the committee’s communications. Will the FOMC be hawkish or dovish? The Fed has repeatedly said they are data dependent and not tied to the calendar. However, as University of Oregon Economist Tim Duy has pointed out: we will need some clarity on which data they are dependent on.

In my view, the case for promising to raise rates again soon is that continued strength in the economy will move unemployment below the natural rate by a fair amount and perhaps for an extended period. In the view of Vice Chair Stanley Fischer for example, such labor market strength would risk setting off enough of an inflationary process that even larger rate hikes would be necessary to contain it.

However, I believe there are several complicating factors to give the Hawks a pause. First, is the tightening of financial conditions reflected in higher rates for corporate borrowers as well as the volatility and general decline of equity prices.  Second, inflation expectations, while hard to measure, may be declining. Inflation expectations derived from market prices are substantially lower than they were a year ago though survey-based expectations may have stabilized.  The chart below shows five year forward forecasts of CPI from surveys an derived from market prices.

infl.png

Source: Bloomberg, Federal Reserve bank of Philadelphia

My prediction is the Fed will raise not rates in either March or April and instead, focus on the tightening in the financial markets and weakness in inflation expectations in its released statement.  Therefore I am expecting the Fed to promise two or more hikes in 2016.   My preference (if I were a voter) would be for the Fed to make it clear that it is willing to be symmetrical around the 2% inflation target and would tolerate a year or two above the target as we have spent each of the last 8 years below it.

Conclusion

Overall, I am pleased to see continued growth in the US despite the tepid international environment. I expect the Fed to try to move back towards, but not fully achieve, its plan of four hikes this year.


All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. The investment return and principal value of an investment will fluctuate and an investor’s equity, when liquidated, may be worth more or less than the original cost.
The Astor Economic Index® is a proprietary index created by Astor Investment Management LLC. It represents an aggregation of various economic data points: including output and employment indicators. The Astor Economic Index® is designed to track the varying levels of growth within the U.S. economy by analyzing current trends against historical data. The Astor Economic Index® is not an investable product. When investing, there are multiple factors to consider. The Astor Economic Index® should not be used as the sole determining factor for your investment decisions. The Index is based on retroactive data points and may be subject to hindsight bias. There is no guarantee the Index will produce the same results in the future. The Astor Economic Index® is a tool created and used by Astor. All conclusions are those of Astor and are subject to change.

303161-375

January Quick Read on the US Economy

The US continues to post moderate growth, though pockets of weaknesses remain.  Global financial markets started the year trying to read the magic eight ball of the Chinese equity and currency markets – a recipe for emotional distress.  Overall, my judgement about the current expansion remains unchanged with slightly above-average growth.

The US economy

·         Our Astor Economic Index® (“AEI”) shows growth somewhat above the ten-year average and slightly better than last month.  The AEI is a proprietary index that evaluates selected employment and output trends in an effort to gauge the current pace of US economic growth.

Source: Astor calculations

Source: Astor calculations

·         The most important and timely indicators for December 2015 were mixed.  On the positive side, payrolls were quite strong and above expectations.  The only quibble with last Friday’s report being recent signs of wage growth seem to have stalled.  I believe a sustained period of real wage gains will be necessary for a robust consumer sector and hence a strong economy.

·         On the bad news side, the weakness in the manufacturing sector as measured by the ISM Purchasing Managers Index continued.  Industrial production, as measured by the year-over-year change in the Fed’s industrial production index, turned negative for first time since the recession in last month’s release.  I tentatively started calling a manufacturing recession last month and I feel a bit stronger about that now.  The non-manufacturing PMI is still fairly strong and though it is off its recent highs, it is still about the average level in the current recovery.

Source: Federal Reserve, Astor calculations

Source: Federal Reserve, Astor calculations

·         While I still see the current (that is, for early 2016) state of growth  as above average, it is looking like the fourth quarter will see a weak GDP print.  The Atlanta Fed’s GDP Now project is currently forecasting growth below 1% (quarterly SAAR).

The Fed

·         The Fed finally began to raise rates with its December meeting.  2016’s market volatility, on its own, is unlikely to cause the Fed to reconsider its path unless it gets more extreme.  It is said central banks tighten according to plan and ease in reaction to events.  The consensus seems to be that the Fed’s plan is to tighten a quarter point at every other meeting or so for a while, as long as the economy continues to hold its present course.  Weak inflation prints, however, could give the FOMC pause.  With energy prices moving lower again this year it is hard to see early inflation prints being strong.  See Tim Duy’s dissection of the December minutes for more.

·         If the Fed does stay the course, the next big obsession for Fed watchers will be when they will begin to allow their QE investments to roll off.  The Fed currently reinvests coupon and principal payments on its portfolio in similar securities so as to maintain a level portfolio.  The first step to reducing the balance sheet will be to cease this reinvestment.  (For a dated but still, I think, correct description see my Cleaning Up After The Party Is Over).  Expect fevered commentary about the issue this summer if nothing else spices up the dreary lives of central bank observers.

The international environment

·         My reading of the global picture has not changed.  The fundamental fact of the global economy today is the weakness in China and the attendant disruption in the supply chains built up to feed its growth.  I believe we see this result in the broader commodity weakness as well as the manufacturing weakness discussed above.

·         There is a great deal written on the Chinese economy, not all of which increases understanding.  A few pieces I appreciated:

o    Noah Smith on why we might not have to fear the Chinese stock market

o    Martin Sandbu on what we should be afraid of (Chinese capital flows)

o    Paul Krugman on when China stumbles.

·         Note too that the US is not alone, the UK’s industrial production also recently turned negative year-over-year.  Globally, the GDP-weighted manufacturing sector PMI has been declining steadily for the last 18 months, though it is still above the lows seen in this measure in 2012.  Note too that those low levels were associated with a stagnation, not a decline, in the level of global industrial production.

Sources: Bloomberg, Markit, IMF, Astor calculations

Sources: Bloomberg, Markit, IMF, Astor calculations

·         In addition to the diffuse reduction in commodity demand, there is an energy specific supply shock.  One can imagine this an oily game of chicken among suppliers waiting to see who will take remove supply from the market first.

Conclusions

Overall, I see the US as currently in modest growth and perhaps we should be pleased the Economy has done as well as it has in a challenging external environment.

 

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. The investment return and principal value of an investment will fluctuate and an investor’s equity, when liquidated, may be worth more or less than the original cost. 

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How the Fed Sees Inflation

The Fed sees inflation a bit differently than many in the markets do.  In this note I will discuss some of the folk-economics that get talked about casually on the trading floor. I will contrast that with how Janet Yellen has recently described her view of US inflation dynamics (mainly as expressed in her very interesting speech Inflation Dynamics and Monetary Policy).

If you feel like you have a good handle on how inflation works, maybe you should think again.  Macroeconomists in general would not describe inflation as a well-understood problem.  Economist Noah Smith, for example, says baldly that “macroeconomists don’t yet understand how inflation works.”  Despite that chastening counsel, many of us have simple models of inflation that we use.

For example, perhaps inflation is caused by commodity prices.  Roughly, copper gets expensive so wire gets expensive so electronics get expensive so everything gets expensive.  Those of us with memories of the 1970s and the high oil prices are particularly susceptible to this.  And to be sure, in the 1970s inflation and commodity prices did increase together and some economists have found a statistical relationship in that blighted decade.  In the more recent period, however a rise in energy prices in one year will not forecast a rise in inflation in the following year (see this paper by Kansas City Fed economists Todd Clark And Stephen Terry, for example).

Since 1980, however, it is tougher to find a consistent pass-through from commodity prices to broader inflation.  What we actually tend to see is prices of commodities tend to fluctuate widely, and hence CPI tends to move more than core CPI.  But the equation seems to be that the ex-food and energy CPI tends to be more stable than CPI including commodity prices.

Source: Bloomberg

Source: Bloomberg

To be clear, of course if gas prices go up 10% today that will have an impact on today’s inflation.  What is not so obvious before careful investigation is that it will have little direct impact on tomorrows inflation.

Do rising wages forecast changes to inflation?  Like commodity prices, this is an intuitive idea without empirical support in the United States since the 1980s.  A summary of the state of research can be found in The Passthrough of Labor Costs to Price Inflation Peneva and Rudd.  This research undermines the idea of a wage-cost spiral operating recently in the US, and instead suggests the preferred interpretation is high wages are an indicator of a tight labor market.

What does cause inflation?  The prices of inputs to production, especially imports, matter for inflation as does the level of resource utilization.  But, again, this is only for the current level of inflation.  What can we use to forecast tomorrow’s level of inflation?  For the longer trend around which prices fluctuate, however, economists have settled mainly on the idea that one of the most important determinants of inflation is inflation expectations themselves, or more precisely, the difference between realized and expected inflation.  This is called the expectations augmented Philips curve.

In some sense, regressing from inflation to expected inflation does not sound like it solves much. What causes inflation expectations in their turn?  The expectation of inflation expectations?   Nevertheless, this seems to be the best that economist have for the time being.  People make plans and contracts based on some sort of expectation of inflation and when the world does not meet their forecast the adapt in some way.

The great thing about stable inflation expectations is that once you have gotten the expectations to a level you are comfortable with then prices should revert to target as people assume that moves away from the target will be reversed.  The bad news is if expectations are stuck away from the desired level, small deflations tend to move back to the bad level too.  The Fed feels it has built up some credibility by moving expectations to around 2%, the target which was implicit for the second half of the Greenspan years and which because explicit under Bernanke.  I believe a large part of the motivation for the balance sheet expansion (QE) was to take insurance against inflation expectations becoming anchored significantly below 2%.

An important question is whether inflation expectations are indeed well anchored.  Presumably, businesses and consumers extract some sort of trend rate of inflation when making expectations.  A long period of actual inflation away from the target will likely eventually shift inflation expectations.  However, no one knows the parameters of such a function.  The Fed has undershot its 2% target much more than it has overshot it, and its extreme actions to move inflation back to target in the last few years have not been successful to date.  The Fed believes that is because of temporary factors which should wash out over time.  We shall see.  The reality is that actual inflation expectations, however measured, have come down dramatically since the crisis and have not recovered.

Overall, then, the Fed thinks it can solve its inflation mandate by reacting with studied earnestness to sustained tightness in resource utilization because this could lead to the extended bouts of inflation that could shift inflation expectations away from the target.  At the same time they can look though inflation caused by temporary changes in market prices of currencies or commodities, as these do not forecast future levels of inflation.

How does this play into the Fed’s current decision and likely course of hikes?  Here is my interpretation based on closely following what FOMC members are saying: The Fed is raising rates a small amount now so it does not have to raise them a large amount later.  This calculus is all based on keeping inflation expectations well anchored.  The Fed feels resource utilization is tight enough that it needs to ensure the economy does not experience a protracted bout of high inflation.  To that end, it seems to slow growth slightly.  The alternative, in the Fed’s view, is in the medium term there will be a long period of above target inflation which will take a substantial slowdown in the economy to contain.

Source: Bloomberg

Source: Bloomberg

I think it is possible to disagree with this logic. I would likely vote against a hike if I was on the board, but it does make sense.  Given the tepid realized inflation figures over the last fifteen years, it also suggests to me that the Fed will not raise rates much.  My guess is 25 basis points every other meeting for the next year, leaving fed funds at about 1% a year from now.  Note that at that level, real rates would still be negative, and thus the Fed will still be “easing”, though at a reduced level.  I expect Low and Slow to be the watchwords for the Fed in 2016.

[Edited 2015-12-17 to add various links accidentally dropped]

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