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Thursday, June 19, 2014

Merrill Lynch: Inflation: bump up or bust out?

by Calculated Risk on 6/19/2014 06:55:00 PM

There are some key questions about inflation right now. Will the recent pickup in inflation continue? Or was it just "noise" (As Fed Chair Janet Yellen said)? This will be important to watch.

Here are some excerpts from an article by Merrill Lynch Global Economist Ethan Harris Inflation: bump up or bust out?

One of the great ironies this year is that even as growth has disappointed to the downside, inflation has surprised to the upside. Most important, in the past three months, core CPI inflation has risen at the fastest rate since before the crisis. Moreover, the pick-up is fairly broad-based. Both goods and services inflation is higher and there appear to be only a couple anomalies—strong apparel price inflation and a huge 41.6% annualized jump in airfares.

Despite the strong numbers, we are reluctant to make significant changes in our inflation call. ... we have incorporated the spring surprises and have raised our sequential forecasts slightly, but that only raises our annual numbers by a few tenths. Why the limited response? To put it simply, the fundamentals don’t support a strong sustained increase. Let’s take a look at the main inflation stories.

Reserved money growth
Since the beginning of the economic recovery, monetarists have argued that with the Fed’s massive balance sheet strong inflation could be just around the corner. Our response has always been: reserves are not money, and unless those reserves stimulate a surge in bank lending and spending, they are not inflationary. ... even with the recent pick up in business lending, overall bank lending is still growing at half the normal pace of a business expansion. ...

Medical mal-pricing?
Another key inflation concern is that special factors have temporarily held inflation in check and are now reversing. There seems to be an element of this in medical inflation. Inflation dipped last year as government payment rates were reduced and as key drugs became generic. Thus the medical PCE price index fell 0.45% in April 2013 and then rose 0.20% this April. That swing alone added more than a tenth to year-over-year core PCE inflation. However, we are reluctant to extrapolate the recent strength going forward. ...

It’s a small world after all
In our view, one of the most underrated factors in recent inflation movements is the impact of global markets. ... In recent months, there have been some signs of a bottoming out of consumer import prices. However, a significant acceleration seems unlikely. The conditions that created the low inflation are still in place: emerging market growth remains low, there is abundant spare capacity in the global economy, the dollar is trending higher and Europe is at risk of sliding into deflation. The main upside risk comes from commodity prices, but usually that takes some time to develop.

Weak wages
While there is a lot of talk about higher wage growth, there is very little evidence. .... In our view, there is still some slack in the labor market; when slack disappears, the rise in wage growth will be very slow, and as Yellen made clear at the press conference, the Fed will welcome the initial rise in wage inflation as a sign of normalization rather than inflation.

... Put it all together, we continue to expect a slow rise in inflation, allowing an equally slow Fed exit.