Oil Pulls Back Amid Heightened Inflation Concerns

The Week Ending Friday May 25th 2018

This last week was light on outlook-changing information even if it was rich in geopolitical news, with Trump’s North Korea peace summit in doubt, and Macron lauding Russia’s President Putin.

Financial Media have focused more than usual on idiosyncrasies of individual firms, canned personal finance stories and geopolitical events this past week, as little of note has happened in markets. Our US NGDP forecast, which runs off recent NGDP growth trends and the signal from several financial markets, is consistent with this take.

The forecast has been steady since April, hovering just north of 4.0%. The statistical models behind the forecast see NGDP growth cresting in the current quarter, and reverting back toward the long-run average of about 3.7% yearly through 2018 and into 2019. It will take a surprise in measured NGDP, or a big upswing in market sentiment to change this.

The S&P 500 has held steady around 2,700 since early May, the 5-year yield, 5-year TIPS spreads, and shorter-dated US government debt just have not moved in any way worth reporting. The dollar index rose 0.6% Friday-to-Friday last week, a usually bearish sign for NGDP, while WTI crude futures have dipped from over $70 per barrel, to about $67, a drop well in excess of that explained by the stronger dollar, which at least allays some fears of runaway petrol prices. It looks as though we are headed back toward the old regime of weak NGDP growth following a one and a half-year ‘Trump bounce’. As the President himself might say: “Sad”.

The yield curve didn’t change much last week, but it’s worth recalling how it looks. The 1-month yield mirrors Fed Funds at 1.75%, 2-year yields are at 2.5% and the 10-year yield just under 3%. This suggests markets see only 75 basis points of additional rate hikes in the next two years, and only 125 basis points over a 5-year horizon. A US economy creaking along at just under 4% NGDP growth simply can’t endure high interest rates.

Data

There was little in the way of interesting economic reports released last week, though this week will see a revision to NGDP as well as a Personal Income report, with the all-important PCE Chain-type Price Index, the Fed’s favored measure of inflation coming out on Thursday, May 31st.

The monthly jobs report will be released on Friday, as will Motor Vehicle Sales. Both the GDP revisions and PCE inflation releases could be outlook changing, as recent NGDP trends can move the forecast, and PCE inflation can tell us something about the likelihood of a revision to Fed policy.

The “Trump bounce” has been associated with a disappointing jump in the PCE inflation rate, both core and headline, to the point where year-over-year core inflation is within 0.1 percentage point of the Fed’s implicit 2% inflation ceiling. The sad fact is that the Fed does not particularly care about long run inflation, but rather that inflation rates in any given month remain below the arbitrary 2.0% threshold, presumably because this makes them look good in the eyes of the financially unsophisticated.

We’ve mostly abandoned hope of the Fed being forced into seriously lifting the NGDP growth rate.  We are instead concerned with market-based measures of inflation expectations, such as TIPS spreads, and measured inflation, particularly the PCE index.

Although the Fed is unlikely to repeat the disastrous blunders of the Bernanke FOMC, namely plunging the economy into a world-historical depression over a few quarters of 2.3% inflation, we shouldn’t overestimate the Fed’s post-Bernanke competency or compassion.

If measures of year-over-year inflation start consistently coming in over 2%, you can be confident the Fed will engineer another NGDP growth slump, as it did in 2014-2016. The primary motivation for this phobic reaction to the 2% ceiling seems to be a desire to ‘bank’ years of low inflation, so that the Fed can prop up the economy in the event of a serious negative supply shock.

It is farcical that the economic fate of so many hinges on small changes in a statistical construct like PCE inflation, rather than something we can be confident about: NGDP.

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