U.S. Inflation: The Undercurrents of Seemingly Calm Inflation

Competing dynamics have kept U.S. inflation largely stable, but the balance may be shifting.

After the turbulence of the 1970s and early 1980s, U.S. inflation entered a remarkably stable period that has persisted for the past three decades. As Figure 1 shows, U.S. core Consumer Price Index (CPI) inflation (which excludes the more volatile energy and food categories) has remained in the 1%–3% range in recent years. Yet under the calm surface, a number of inflationary and deflationary dynamics are in play. While these forces have so far roughly offset each other, we think the deflationary pressures may diminish or even reverse going forward, causing overall inflation to break out of its flat trend. Persistent trade tensions, a potential shift toward deglobalization, and rising labor costs in China may cause inflation to settle higher than the benign levels we’ve seen over the past decade.

Given these dynamics, careful monitoring of inflation and its potential impact on portfolios will be critical for investors. And with markets still largely complacent about inflation prospects, we believe hedging against U.S. inflation risk with Treasury Inflation-Protected Securities (TIPS) remains affordable.

Figure 1 is a graph of U.S. core CPI inflation from 1960 to November 2019. CPI has been calm in recent years, hovering around 2%. It peaked around 1980 at almost 14%. Other peaks include around 1970, when it was about 6%, 1974, when it reached almost 12%, and the early 1990s, when it reached almost 6%.

Beneath the surface: a wide gap between services and goods inflation

The gap between services and goods inflation has tended to vary over time, remaining positive for long stretches only to close up again before reappearing later (see Figure 2). Some observers have attributed this phenomenon mainly to currency moves, pointing out that goods inflation is tied to import prices and that a stronger currency leads to lower prices for imports. While this dynamic has certainly been in play, we think it is not the only driver, given that many countries have experienced such shifts in the absence of appreciating currencies.

Notably, since the 1990s, we’ve seen the gap turn positive and grow, meaning that services prices have risen significantly faster than goods prices. As Figure 2 shows, core services inflation has remained in a narrow band of 2%–4% except during a brief period at the end of the Great Recession, while core goods inflation has bounced around 0% and was even in outright deflation in recent years, dragging overall inflation down. Moreover, services now make up a much larger part of the inflation basket, having risen from about half in the 1970s to roughly 70% today, offsetting the deflationary drag from goods inflation. We agree with a McKinsey paper1 noting that services’ rise in prominence is likely to continue given consumers’ growing preference for “experiences,” although at a lower speed relative to history.

The deflationary period for goods also coincided with a faster pace of globalization, and especially the growing influence of China. Beijing introduced its modern exchange-rate system in 1994, leading to a massive overnight devaluation of the yuan against the dollar, and joined the World Trade Organization (WTO) in 2001. The subsequent inflation moves reflect goods prices’ greater sensitivity to the effects of globalization, import prices, and foreign exchange (FX) moves relative to services prices, which are more closely linked to domestic demand/supply dynamics.

Figure 2 shows a graph of U.S. core inflation of CPI services versus goods, from 1980 to November 2019. Core CPI goods has hovered near zero for several years, trailing well behind inflation for services, which has been around 2.5% to 3% over same time period. Inflation for services has outpaced that of goods for most of the time span.

This reality is reflected in the inflation spike for some goods most affected by tariffs on Chinese imports (as discussed below), as well as in the divergence of the Phillips curves for goods and services. As Figure 3 shows, goods inflation has been unresponsive to changes in unemployment, manifesting no evidence of a Phillips curve. For services, on the other hand, the Phillips curve is alive and well, evidence of a continued strong inverse relationship between services inflation and unemployment.

Figure 3 shows two scatter plots, one showing the Philips curve for services, and one for goods. For services, the plot shows a negative slope of unemployment versus core services for both 2000s and 2010s, meaning that as unemployment goes down, inflation goes up, in line with the Philips curve. For goods, there’s a positive slope for each of those, showing that goods inflation has been unresponsive to changes in unemployment, meaning the Phillips curve is not in effect for that segment.

Inflation outlook: Three key factors could push inflation up

These dynamics feed into our near-term outlook for inflation. We expect a modest acceleration in U.S. core CPI to about 2.5% over the next several months as companies increasingly pass on the costs of tariffs to consumers, before tailing off toward 2.2% at the end of 2020. Monetary policy and potential fiscal policy should also bolster inflation expectations. The Fed is still more worried about slowing economic growth than overheating. We think the Fed is unlikely to shift toward another tightening cycle anytime soon, even if the economic data and inflation surprise to the upside. Chair Jerome Powell’s press conference following the latest rate cut indicated that the Fed is comfortable with allowing an inflation overshoot.

Looking further out, we think inflation in the U.S. will reside higher than the benign levels we’ve seen over the past decade, for three main reasons:

  1. Trade tensions between the U.S. and China will likely persist. Trade tensions are a source not only of inflation itself (mainly affecting goods), but also of inflation volatility. We think a quick resolution is unlikely, and despite recent headlines suggesting that a potential “Phase 1” deal may ease tensions, we believe this would amount to a reprieve rather than a true de-escalation. Moreover, we are just now seeing the initial phase of the pass-through of tariffs to consumers, with a spike in inflation for tariff-impacted goods (see Figure 4).
  2. Figure 4 shows a 12-month moving average of CPI for tariff-sensitive sectors, from 2013 to November 2019. From 2013 to 2018 the CPI ranges roughly between minus 4% and minus 8%, after which it breaks above that level, hitting positive territory briefly in 2019, before pulling back to minus 0.5% in November. Categories affected by tariffs include appliances, household equipment, hardware tools, outdoor equipment, video and audio products, and photographic equipment..

  3. Globalization may be peaking. Related to the prior point on trade tensions, a deceleration of imports in the U.S. and globally in recent years (see Figure 5) may indicate that globalization is peaking and possibly slowing down, which would alleviate the deflationary drag from imported goods. Taking this one step further, rising populist sentiment in the U.S., the U.K., and the eurozone could fuel a trend toward deglobalization, which would tend to be inflationary. Indeed, deglobalization was among the topics discussed at the recent IMF/World Bank meetings in Washington, D.C., and a key takeaway was that U.S.-China tensions are likely structural, not cyclical.
  4. Figure 5 shows a graph over the last six decades of imports of goods and services as a percentage of GDP, with one line showing world imports, and one showing imports for the U.S. Both had increased over the time period, with one setback during the last financial crisis. World imports by September 2019 had fallen to about 28% of GDP, down from 30% in 2011. Similarly, U.S. imports dropped to 15% of GDP, down from about 17% over the same time period.

  5. Chinese employment costs are rising. Labor costs in China have risen sharply over the past two decades (see Figure 6), outpacing growth in the developed world by a wide margin. This trend could ease the past deflationary effect of lower relative labor costs.

Figure 6 is a graph of labor costs in China versus other nations. With unit labor costs indexed to 100 in 2000, China had reached 270 by 2018, much higher than 140 for the U.K, 125 for the European Union, and 120 for the United States. Japan’s labor costs were lower in 2018 than in 2000, at around 90.

Technology: a confounding factor. The impact of technology is one factor that could lead us to revise our outlook. Traditionally, technological advancements have led to higher productivity and slower inflation. They have also influenced the hedonic quality adjustments made to inflation indices like U.S. CPI that aim to remove any price differential attributed to a change in the quality of a product. Given the deflationary impact technology has already had, we think its impact is unlikely to accelerate from here. Nevertheless, we carefully monitor and examine developments related to technology.

Investment implications: TIPS look attractive

We remain constructive on inflation-sensitive assets like Treasury Inflation-Protected Securities (TIPS) given our view that near-term U.S. inflation surprises will likely tilt to the upside amid trade uncertainties, Fed easing, and a growing fiscal deficit. Moreover, we view starting conditions for TIPS as quite favorable: Breakeven inflation currently indicates expectations for just 1.6%–1.7% headline CPI inflation in the U.S. over the next 10 years; this is significantly lower than the Fed’s stated target of 2% personal consumption expenditures (PCE) inflation (its preferred measure), which equates to roughly 2.35% CPI. The cost of hedging against inflation risks with TIPS is thus very low in our view while the market remains complacent about inflation prospects.

In the long run, we expect more historically “normal” inflation dynamics, supported by goods prices that recently climbed out of deflation, a steepening of the Phillips curve, and the re-emergence of a positive inflation risk premium.

Visit our inflation page to learn more about PIMCO’s thinking on the complex drivers of inflation and their significance for investing.

1See “Cashing in on the U.S. experience economy,” published in December 2017 by McKinsey & Company.
The Author

Daniel He

Portfolio Manager

Georgi Popov

Product Strategist



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