" This is not a fluke: almost all of the underlying determinants of inflation point to weakness, " writes BofA Merrill Lynch economist Ethan Harris in a note to clients today.
For all of the talk of rising government bond yields and predictions for when the Federal Reserve will taper back its bond buying, Harris says, deflation is still a bigger risk than higher inflation – and disinflation could cause the Fed to actually ramp up QE if it continues.
Several key measures of inflation are actually headed lower, and have yet to bottom out, according to Harris.
"This, along with the fiscal shock, is a good reason to fade the bond market sell-off," he writes.
The chart below shows Core CPI, Core PPI, Median CPI (calculated by the Cleveland Fed), Core PCE, and Trimmed PCE (calculated by the Dallas Fed).
Harris cites six forces weighing on inflation, summarized below:
- Spare capacity: Official estimates for the U.S. output gap, the difference between potential GDP and actual GDP, range from 3.6 to 5.6 percent – the widest since the 1982 recession. Moreover, the unemployment rate, at 7.9 percent, is still well above BofA's estimate for the inflation-neutral rate (6.3 percent).
- Labor costs: High unemployment is keeping downward pressure on wages and salaries. Harris says that excepting for a distorted number in Q4, unit labor costs have been "essentially flat" over the past year.
- Imported inflation: The huge gains in commodities we've seen in recent years are tapering off, which means the food and energy components of inflation shouldn't provide the same impetus for rising prices as they did in 2011, for example.
- Inflation expectations: Inflation breakevens are near 10-year averages, and an adjusted measure of inflation expectations using data from the interest rate swaps market shows an ongoing deceleration.
- Monetarist mechanism: Despite the massive increase in bank reserves by the Federal Reserve through its monetary stimulus programs, bank lending remains subdued, as does nominal GDP growth. In other words, those reserves haven't made their way to the real economy.
- Rising rents: Harris calls this "the one major area of concern" when it comes to inflation. Over the past year and a half, these measures have stabilized following a sizable increase. "However," Harris writes, "with vacancy rates still low, pressure may return."
Harris says he expects that "inflation bounces around the Fed’s 2% target, with no clear trend over the next two years," but warns:
However, if recent trends continue, we will have to revisit that forecast.
If this downdraft sticks, it has important implications for the long-awaited bond sell-off.
Lower inflation should not only put downward pressure on breakevens, it will encourage the Fed to stick to its QE program longer. If outright deflation threatens, the Fed could even ramp up its program.
More QE – imagine that.
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