MNI INTERVIEW: US Disinflation In Train But Economy Overheated

More U.S. disinflation is in the pipeline but bringing inflation back to 2% will likely require a cooler economy and looser labor market conditions, Dallas Fed economist Tyler Atkinson told MNI.

Shelter inflation is on track to slow over the coming year, with falling rents for new leases set to translate into declines of 1.1 pp in CPI and 0.4 pp in the Fed's preferred PCE inflation measure over the next year, Atkinson said. Some progress on labor market rebalancing and wage growth also points to cooling for core services ex-shelter categories.

Indicators of underlying price pressures are easing as well, he said. The Dallas Fed Trimmed Mean PCE price index has slowed to a 3.4% three-month annualized pace in June from over 4.5% earlier in the year, an "encouraging" sign that the middle of the distribution of prices has moved down. Core PCE prices added just 0.2% in June and were up 4.1% over the year, down from 4.6% in May, while the 12-month headline PCE price index saw its smallest increase in more than two years at 3.0%.

"The June inflation data was definitely good news, but we need to see more of it to have confidence it’s a trend," Atkinson said in an interview. "More importantly, just disinflation is not guaranteed to get us back to 2%. While leading indicators say inflation is likely to fall more going forward, they don't say where it’ll stabilize in a year or two."

STILL OVERHEATED

The U.S. central bank last week raised interest rates by 25 bps to a target range of 5.25% to 5.5%, and Fed Chair Jerome Powell said the FOMC will decide whether to raise rates again in September or later this year depending on inflation and economic data. As prices have come in softer than expected in recent weeks, some investors believe the July hike likely marked the last increase of the cycle. (See: MNI INTERVIEW: Powell Opens Door To End of Fed Hikes-Weinberg)

But Atkinson isn't yet convinced inflation is on a sustained path to 2%, citing tightness in the labor market and general overheating in an economy where demand still outstrips supply.

Job openings and quits rates have decelerated and declined but are still higher than in 2019, he noted, and firms across various Fed surveys say they expect to raise wages 4%-5% this year, above the 3% pre-pandemic level. The number of unemployed persons per job opening, a statistic often cited by Fed officials, edged up to 1.6 in May, significantly lower than its peak of 2.0 but higher than the 1.2 level from 2019. Labor cost growth is highly correlated with measures of non-housing services inflation.

HOUSING INFLATION

On the positive side, the Fed's rapid interest rate hikes have played a key role in keeping longer term inflation expectations anchored at 2%, a prerequisite for getting inflation back to 2% over the long run, Atkinson said.

The housing component of core inflation is also expected to moderate based on private measures of new lease rent growth. Because the Labor Department's rent index is intended to measure monthly changes experienced by typical renters who are unlikely to frequently adjust their leases, the CPI housing component tends to lag measures of market rents.

A forecast developed by Atkinson of rent inflation using CoreLogic's Single Family Rent Index would have accurately predicted the path of rent inflation a year in advance and currently anticipates the 12-month rate of rent and owners' equivalent rent (in CPI) slowing to 5.7% in the first quarter of next year from 7.8% in June. The CoreLogic rent index saw the year-on-year price change spike at 14% but returned to its pre-pandemic levels of around 3% in May, the latest month for which data are available. Rent and OER make up 41% of core CPI and 17% percent core PCE inflation.

"Looking at these markets indexes, we have a pretty good idea that more disinflation is coming," Atkinson said. "But if the economy were to overheat, then those rents would rebound. The labor market is a typically a good reading on the degree of overheating."