The Core Consumer Price Index (CPI) moved higher with the November print from 1.91% year-over-year to 2.02% year-over-year, jumping 0.11% in one month. For reference, core inflation is most often calculated by taking the CPI and excluding certain items from the index, usually energy and food products. From a significance perspective, it has been three years since core CPI was in excess of 2%. With that in mind, let’s pause for a moment and consider notable macroeconomic drivers during the past three years: falling oil prices, the rising U.S. dollar, and global economic volatility. Throughout all these macroeconomic events core CPI has been resilient, moving up from a low of 1.57% in February 2014. Domestic demand, led by tighter labor markets and a robust housing market, have acted as the key drivers for increasing core CPI. And as we move forward, tighter labor markets will likely sustain inflation at a higher level over the next few years.
As I’ve written about for the past couple of months, inflation on a year-over-year basis is now shedding the very low inflation from a year ago. Headline CPI moved higher from 0.17% year-over-year to 0.50% year-over-year. This astounding one month volatility will likely continue over the next couple of months moving overall CPI an additional 1.0% higher to around 1.50% year-over-year. I view this three month volatility to be a catch-up phase bringing headline CPI more in line with a longer term trend. With any move higher in oil prices over the course of 2016, headline inflation, which does include energy and food products, could end the year over 2%.
Regarding the Federal Reserve’s (Fed) preferred measure of inflation, the core Personal Consumption Expenditures (PCE) price index has been on a lower track but will likely move up to its 10-month trend rate of 1.5% annualized from the current 1.3% year-over-year rate in the near future. One way to look at The Fed’s monetary policy conditions is to examine the so called “real fed funds rate”, which is fed funds minus inflation. Over the past seven years the Fed has kept fed funds well below core PCE, providing substantial stimulus for the economy. During this time period, real fed funds has averaged -1.36% providing very attractive borrowing rates for companies, consumers, and governments. Using November inflation, real fed funds is currently -0.98% today.
If the Fed were to move fed funds higher, only to match inflation, actual monetary policy would not be any tighter at all. So, if as I anticipate, core PCE moves higher by about 0.5% in 2016, the Fed in an effort to normalize real fed funds higher, and less negative, will need to raise fed funds in excess of 0.5%. Indeed the median of Fed member expectations is four 0.25% hikes throughout 2016, totaling a 1% increase.
As real fed funds moves higher, expect market interest rates to move higher. Unfortunately, asset prices supported by exceedingly low real fed funds will now need to adjust to a new reality of higher, and maybe at some point positive, real fed funds.
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