In the latest Ahead of the Curve, Silvia Dall’Angelo, Senior Economist at Hermes Investment Management, assesses whether economic expansion in 2018 will herald the return of elusive inflation.
In late 2016, economic expansion entered a new constructive phase, featuring a synchronised upswing in global demand and, in turn, a pick-up in capital investment – an element largely missing from a recovery that had been mainly consumer driven.
The current positive mini-cycle was sustained throughout 2017, helping to erode remaining slack in the economy. In most developed economies, there is arguably little slack left, with the eurozone being a notable exception. Yet, inflation has been conspicuously absent.
Has the Phillips curve fallen flat?
Indeed, across most developed markets inflation has systematically run below official targets and, over the last year, even retreated in places where the output gap has probably turned positive, such as the US. This has led to a renewed debate about the ultimate drivers of inflation and prompted questions about the Phillips curve framework – which lies at the heart of central banks’ models and reaction functions.
For all its limitations and the myriad factors masking it, the short-run Phillips curve still makes economic sense as it predicts that prices need to adjust upwards as demand outstrips supply. This should become more evident in 2018 as the recent acceleration in activity starts to influence prices and the echo effect of the large but relatively recent drop in oil prices gradually fades.
Models point to inflation creep
Typical Phillips curve models for the US and the eurozone suggest that inflation will increase slightly next year, with the US making the greatest progress towards its official target, defined by the Federal Reserve as a growth rate of 2% in the Personal Consumption Expenditures (PCE) price index.
Based on a Phillips curve approach similar to the one used by Fed Chair Janet Yellen, US core PCE inflation should average 1.8% in 2018, up from 1.5% in 2017 (see chart). Granted, special factors imply some upside risk this year. Base effects in the prices of telecommunication services and the recently announced increases in drug prices will provide some boost in Q1, jointly adding 0.2pp (or potentially more) to annual core PCE inflation.
Hence, we see US core PCE inflation increasing in 2018, reversing the 2017 decline, but this is likely to remain slightly below target.
Chart – US core PCE inflation likely to increase in 2018, reversing the 2017 decline. However, it is likely to remain slightly below target. US Core PCE inflation, QoQ SAAR, Actual vs Estimated based on a Phillips curve model.
Source: Hermes Investment, based on data from the BEA, BLS, CBO, Philadelphia Fed SPF and Census as at September 2017.
Meanwhile, in the eurozone, core inflation – defined by the Harmonised Index of Consumer Prices (HICP) – is also likely to keep gradually increasing this year, and possibly accelerate slightly in comparison with the last couple of years. However, given the abundant spare capacity in the economy, core inflation is likely to remain below target and edge up to an average of 1.2% in 2018, rising from 1% in 2017 and 0.9% in 2016.
Runaway inflation unlikely but upside risk lurks
In general, runaway inflation looks unlikely in the near future – but for once there are upside risks. First, while domestically-driven price pressures should re-emerge, China is unlikely to produce the same kind of global disinflation it did from the mid-1990s and other emerging markets are unlikely to take up that role in the short term.
Secondly, automation and globalisation have created winners and losers, which partially explains the recent appeal of populist rhetoric to voters worldwide. It is hard to say whether that trend will persist, but these protectionist inclinations, if fully expressed as policies, have the potential to generate a surge of inflation – and the wrong sort of it.