Bank of the West U.S. Outlook Report for September 18, 2015
US Outlook Report: Low Inflation Gets the Fed’s Attention
The Fed cited risks to the U.S. economic outlook from global economic and financial developments, but what really got the Fed to hold off on raising interest rates in September was the recent behavior and near-term outlook for U.S. inflation. The Fed looked past an improving U.S. labor market this week to refocus its attention on the inflation side of their dual mandate. Despite sticking to their transitory story on low U.S. inflation, the Federal Reserve appears a bit more worried about their confidence in that inflation outlook. Not only did the FOMC lower their median projections for PCE inflation over the next three years, they now have little confidence that the PCE deflator will return to their 2.0 percent long-run objective until the year 2018.
Now is probably a good time to review how bad the deflation picture has gotten in the U.S. recently. Producer prices are the weakest we have seen since 2009. Crude good producer prices are now down 24% from a year ago, and finished goods producer prices are almost 3.0 percent lower than last year at this time. Producer price declines often lead to weaker consumer inflation down the road. If deflation becomes entrenched, it can lead to lower demand, reinforcing the downward spiral in prices and the economy. Moreover, the Fed’s toolkit to fight deflation is limited.
And it’s not just energy prices that are driving the declines. Even producer food prices are dropping at a steady pace.
Moreover, the worst probably isn’t over. Not only did consumer prices fall 0.1 percent last month undershooting economist consensus expectations, but the drop in gasoline prices so far for September should be enough to push consumer price inflation down by another 0.2 percent in September.
From a year ago, U.S. consumer inflation is now just 0.2 percent above year ago levels, about where Europe’s consumer inflation rate was when the ECB started contemplating their own Quantitative Easing program. As you can see in the chart, deflation has crept into several sectors now, including energy, transport, and apparel, while inflation is slowing in all sectors including medical care, services, and housing.
We have cut our own inflation forecasts as a result of these recent trends. We now see U.S. consumer prices dropping 0.1 percent in 2015 with a slower climb over subsequent years. Producer prices of finished goods are forecasted to drop 3.6 percent this year, before slowly recovering to +0.9% in 2016 as energy prices stabilize.
A rise in interest rates now could aggravate these trends by pushing the U.S. dollar even higher and creating more deflationary pressures from abroad.
Both the decline in producer prices and drop in import prices tends to put downward pressure on consumer inflation all else being equal. Even if a tightening labor market were to start pushing up wages, it is doubtful it would overwhelm the headwinds against higher price inflation over the near-term.
So while China’s recent turmoil and tightening of global financial conditions are somewhat concerning for the Fed, it is likely the deteriorating inflation outlook that got the FOMC’s attention and reduced their confidence that U.S. inflation will soon return to their long-run objective pace of 2.0%. Until they see more signs that energy and commodity prices are stabilizing or turning around, the Fed could remain in a holding pattern.
To find out more, check out this week’s US Outlook Report.