MNI INTERVIEW: Odds of Soft Landing Improved - Fed's Kliesen

The odds of a soft landing have improved considerably over recent months as U.S. growth surprises to the upside and momentum builds on disinflation, Federal Reserve Bank of St. Louis economist Kevin Kliesen told MNI.

Most forecasters have removed recession from their baseline scenarios and the July CPI report offered fresh signs of subsiding price pressures, with three-month price growth below 12-month rates, Kliesen said in an interview.

Headline CPI has risen at an annualized 1.9% over the past three months, sharply lower than its year-over-year rate of 3.2%, while core CPI increased 3.1% three-month-annualized, versus its year-over-year 4.7%.

But he cautioned that underlying inflation is still well above target at around 4%, underpinned by resilient demand for services, and rising energy and commodities prices could undo some recent progress on headline inflation.

"It's certainly plausible to me that you can bring inflation down without crashing the labor market, like in the '94-'95 episode," Kliesen said. "But if we continue to have above-trend growth, that last mile on inflation could be harder."

EVEN ODDS

Whereas headline inflation has seen a big decline from 9% to 3% in a year, core inflation is still "pretty far from the last mile," Kliesen said.

Working in the Fed's favor are positive real rates, in the sense that it costs more in real terms to finance purchases -- though there is no consensus on whether policy is sufficiently restrictive -- and anchored longer term inflation expectations that should exert a gravitational pull toward 2%. (See: MNI INTERVIEW: Fed's Athreya-Real Rates Might Still Be Too Low)

One index of future inflation probabilities shows increasingly even odds on whether inflation will stay above target or fall to around 2% over the next 12 months. The St. Louis Fed's Price Pressure Measure, which Kliesen helped develop in 2015, sees a 43% probability that headline PCE inflation will be above 2.5% in a year, down from 73% in May.

It now sees a 46% probability that inflation will decelerate to a 1.5%-2.5% range over the next year.

"It’s a coin toss," Kliesen said. "Clearly the model is wanting to predict a further deceleration."

CORE CONVERGING ON HEADLINE

Over time, headline inflation has tended to converge toward core, but the reverse will need to happen to get inflation back to 2% this time, Kliesen noted. Services inflation tends to be stickier than goods, as seen in elevated core measures, though the large shelter category has peaked and is expected to moderate further. (See: MNI INTERVIEW: US Disinflation In Train But Economy Overheated)

There are also upside risks to headline inflation. The steady climb in oil in recent weeks could add to gas prices in the next few months, Kliesen said. This year's strengthening El Nino weather patterns are also typically associated with rising commodity prices globally, Kliesen said.

Crude is up 20% since the start of July, and Saudi Arabia’s cuts to production and increasing global demand and could keep prices rising through the first quarter of next year, according to the latest U.S. Energy Information Administration forecast this week.

"There are still a lot of data to come," Kliesen said. "The inflation fever may have broken or be breaking, but we’ve been fooled before."