USA – The risk of rising inflation is limited

Investors and economists are now very attentive to the US labor market momentum. Its profile is expected to give information on the future of inflation and on the reaction of the Federal Reserve.
Since April 2014 the number of new jobs is 260 000 on average each month. It’s a pretty strong number. This new situation is expected to create new pressures on inflation that will force the Fed to change its monetary policy. Until now this equation doesn’t work. Wages momentum is not stronger in the recent past. (see here a description of the US labor market with June figures)
Inflation momentum will not come from the labor market directly even if there are a large number of new jobs. Two charts will convince you

The first chart shows the consistency between Unit Labor Costs (ULC) and jobs’ monthly change. I use ULC instead of the Employment Cost Index (ECI) as there is a correction for productivity. It better represents how labor costs weigh on companies. Employment is monthly change with a lead of 12 months.
USA-en-2014-T2-ULC-JobsThe two profiles are a representation of the business cycle. Peak and trough of the two series are consistent. But there are accelerations on the ULC that are specific and do not come from the labor market. Usually they have a low persistence.
Looking at the chart, there are no specific pressures to expect a higher ULC momentum in the coming months. Even with strong jobs’ creation, the risk appears to be limited.

The second chart shows the consistency of ULC and core inflation rate (from the PCE index).
USA-2014-T2-ULC-CPIOn a very long time period (almost 55 years) we see a kind of common trend between the two indicators. In the recent period, the ULC index is more volatile but there is no persistence and this does not translate in a higher or lower inflation rate. To expect a higher inflation rate we need to expect that shocks on ULC will be strong and will have persistence as it was the case in the late 60’s or the early 70’s.

The current labor market momentum, even if it is strong, will not create spontaneously higher and persistent ULC. In that case the risk of higher inflation is reduced and the need for a tighter monetary policy stance is not required.

What could be the sources of a higher inflation rate?
To change the inflation momentum, there is a need for strong and persistent shocks on ULC. This could come from a change in inflation expectations or from new rigidity on the labor market or from a lower productivity dynamics.
Inflation expectations do not change a lot recently. The two charts below show consumers and investors’ expectations. On the left graph, we see that households have very stable expectations. On the right chart we see that investors do not expect a rapid and deep change in the inflation rate dynamics. So this is not a good candidate for being a catalyst on higher inflation expectations
USA-en-inf-expectationsOn the labor market, rigidity do not seem to have strengthened recently. In a recent NBER working paper it was shown that the short-term dynamics of this market was back to normal. What has changed is the dynamics with long-term unemployment. It’s something we have to look at but which doesn’t seem to be a source of higher ULC (see here)
Lower productivity can be a source of persistent higher ULC. Recent low productivity momentum is a source of concern. The chart below represents productivity change. The blue area is the one year change. It is volatile and not easy to read. The purple line is the 4 year change (at annual rate) and we better see its cycle. During the first half of 2014 productivity is low.
This reflects two important issues:
One is the capability to innovate again and to feed this productivity. This is an important debate notably in the US. Here is a discussion in the Wall Street Journal between Robert J Gordon who think that major innovations have been done and Joel Mokyr who believe that we still have important innovations to discover (see here and see in the videos the tag on New Technologies; specifically the Ted’s videos with Gordon and Brynjolfsson)
The other issue is that if productivity momentum remains low, the capacity to get a surplus is reduced. In that case lower profitability could lead to inflate prices. The temptation is to become a price maker because profitability is too low (that’s what was seen in the 70’s. Today due to globalization it is harder to have this kind of behavior)
The good question here is the capability to invest and to improve human and technological capital. For me in a context of low growth this is the major question.
usa-en-2014-Q2-ProductivityULC will still be volatile but currently there is no real source of persistence. For me the major risk is on productivity and on investment. That’s why we are very attentive to this issue to try to anticipate the inflation profile.
In the short run, I don’t think that a change will take place. Then the Fed will have to take more attention on economic activity than on inflation. The US central bank will then not be in a hurry to hike its interest rates.

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