When Should We Start Worrying About Inflation?

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by: Scott Sumner

Jan Hatzius is now forecasting that inflation will soon exceed the Fed's 2% target for the PCE:

Goldman's Jan Hatzius wrote Sunday that unemployment should continue to decline to 3% by early 2020, noting the labor market also has room to accommodate more wage growth. Hatzius predicted that average hourly earnings would likely grow in the 3.25% to 3.50% range over the next year.

That rapid pace of wage growth could set the Fed up for a "meaningful overshoot" of its 2% inflation target.

"If unemployment is (perhaps well) below 3.50% and inflation above 2%, we think Fed officials will need to be quite confident that growth will stay at or below trend to sound an all-clear on further rate increases, which could translate into a large easing in financial conditions and a return to growth rates well above trend," Hatzius wrote.

Hatzius wrote that the economy needs to slow to avoid overheating, and worries that inflation could run away if the Fed does not take action. For now, Goldman has a baseline forecast of 2.3% for core PCE - which it noted as within the Fed's comfort zone - but warned that inflation is poised to move higher on President Donald Trump's tariffs.

The note also warned that with the labor market continuing to tighten, inflation will likely push "notably, not just slightly, higher."

Hatzius said a slowdown could stabilize the unemployment rate, and already predicts that the economy will calm to a GDP growth rate of 2.6% in the fourth quarter. But if the slowdown is not enough, unemployment could destabilize into 2020 and inflation could run rampant.

If Hatzius is correct (and I greatly respect his judgment), then Fed policy is currently too expansionary. The Philadelphia Fed consensus forecast is for 2.1% PCE inflation in 2019 and 2020. (I'll be very interested in the next forecast, which should be out soon.) On the other hand, TIPS spreads continue to show sub-2% inflation over the next 5 years (once adjusted for the CPI bias) but they are subject to bias from a modest risk spread.

So what would tell me that we have an inflation problem? Lots of news articles saying "It's not that bad, because if you take out the rise in the price of X, inflation is only running at Y." I saw literally dozens of such articles in the 1960s and 1970s, and essentially 100% of them were incorrect.

It is true inflation indices can be distorted by the actions of individual markets, but only if it reduces aggregate supply. In that case, you'd see rising inflation, falling RGDP growth and modest NGDP growth. In fact, both NGDP and RGDP growth have recently been quite strong, so don't believe any articles about it not being so bad because it's concentrated in healthcare, or education, or rents, or tariffs, or kiwi fruit prices, or some other special factor. Special factors are not an excuse when NGDP growth is at a pace that is unsustainable if we hope to keep inflation close to 2%.

I'm not a forecaster, so I'm still pretty agnostic on this. My baseline forecast is still for a slowdown in NGDP growth (predicted by the Hypermind market) and no recession or high inflation in the near term. That's good. But I'll be watching very closely for signs of excess. The most likely policy mistake being made right now is too easy, not too tight.

PS. Hypermind is currently forecasting 12-month 5.2% NGDP growth. That represents a forecast of a slowdown to 4.2% over the next two quarters, from the 6.2% (actual) rate over the past two quarters.