US + Brazil Financial News (11/13)

The downturn in US core inflation in 2017 continues to trouble markets and likely accounts for a major part of the discrepancy between the market’s forecast of future policy rates and the Fed’s own forecasts, which are significantly higher. The October reading, out this Wednesday, is the last one before the next FOMC meeting on December 12-13, two days before the November CPI release. Abstracting from the headline, that for energy-related reasons could dip down in October, core inflation is expected to hold steady and return to 0.2%momsa or 1.7%yoy. The issue, of course, is that this is low, too low some may argue for a central bank bent on normalizing interest rates, suggesting it will deliver 100bp of hikes over the next 12mo, approximately. And the related question is, is there something fundamentally different with today’s inflation? Extending further to the equally surprising low rate of wage gains in an economy already at full employment, is there something fundamentally different between the relationship between output and prices, wages and employment, that guides monetary policy?

Many have looked at these issues recently and, contrary to the crusaders who want to throw away the economics textbooks, they find sensible answers. They find that inflation rates for prices that tend to be sensitive to the cycle moved back up to around pre-recession levels as the economy recovered. They also find that inflation rates for other categories that tend to be less sensitive to the cycle fell a lot and remain low. This is the case with inflation in services. At a more granular level, services categories contribute the bulk of the decline in core inflation, and healthcare most of all. Meanwhile, core goods inflation is currently above its pre-crisis trend. Moreover, this contrast between higher goods and lower healthcare inflation is the case not only in the US, also in other large advanced economies.

Much as these researchers looked for it, they found no evidence of the so-called “Amazon effect.” It turns out that disruptive technologies, while they benefit greatly the consumer, do not, in fact, “annihilate” the price margins of producers. The causes of weak inflation in 2017 are a combination of transitory, idiosyncratic factors coupled with a more persistent but nonetheless waning drag from services, notably healthcare. As these effects diminish, and tight labor markets with an economy expanding above its potential push inflation higher for prices that tend to be sensitive to the cycle, inflation should move up. Some measures of inflation show this already. For example, the Federal Reserve Bank of Atlanta estimates what it calls an “underlying inflation index.” This is the inflation rate for items in the CPI whose prices change less frequently, the “sticky price inflation”. By this count, “trend CPI inflation [is] in the 2.3% to 2.8% range”. To be sure, there is a leap from this simple fact to what the FOMC will choose to do. But here again, the discussion about the “death of the Phillips curve” is vastly exaggerated. The link between output and prices may be “flatter,” perhaps more “non-linear,” but it is there nonetheless—and it calls for the normalization of policy, which is what we expect will continue to happen despite the vagaries of the CPI index.

This is a critical week for hopefuls of social security reform, now involving a rearrangement of Temer’s cabinet to weed out parties that no longer support him and expand space for those that do. The drama is to see if the PSDB—that has fallen to bad times with apparently insurmountable internal differences—will pull out of Temer’s coalition.

On the data front we get new evidence of the continued expansion in retail sales. Through August, retail sales accelerated steadily in Q2/17 to 3.3%yoy. Meanwhile, the smaller subset of “expanded retail sales” that includes vehicles and construction materials did even better, with growth rates accelerating steadily in Q1 and Q2/17 to 7.9%yoy in August. Partly the trend in retail reflects the recovery in real incomes and, surprisingly, in employment—this early in the tepid recovery cycle. It also reflects a sharp drop in relative prices, with the retail price deflator falling ahead of general inflation during this deflationary period. Last week’s inflation (IPCA) data brought the six-consecutive month of deflation in food prices. On Tuesday, we get the information for September. The trends should continue. The consensus estimate is 4.5%yoy; with a faster growth on the broader index.