Five Potential Inflation Surprises for 2018
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1 Economics Group Special Commentary Sarah House, Economist (704) Ariana Vaisey, Economic Analyst (704) Five Potential Inflation Surprises for 2018 Inflation came strongly out of the gate in After nearly half a decade below the Fed s target, the PCE deflator reached 2 percent in January amid a rebound in energy prices and pickup in core inflation. It looked as if both parts of the FOMC s dual mandate were finally giving a clear greenlight to raise interest rates. That all came crashing down in March, however. Core inflation fell 0.2 percent, which was bigger than the cumulative decline registered over the entire Great Recession. Driving the drop was a 7.0 percent decline in wireless phone services as falling plan costs coincided with new ways in which the BLS adjusted for changes in plan quality. Although only a sliver of the CPI with a weight of 1.5 percent, the drop in March was enough to subtract 0.2 percentage points off the year-over-year rate of headline inflation and kick off a run of disinflation that lasted through the summer. Could we be in for another such surprise in 2018? Our baseline forecast is for inflation to slowly strengthen over the course of the coming year. Further tightening in the labor market and the unwinding of what we believe to be largely one-off effects should push inflation higher. A 5 percent decline in the dollar since January and stronger global inflation should also lend some support to core goods prices as import prices rise. Offsetting the upward thrust of these dynamics, however, is likely to be further declines in the prices of autos as replacement demand from recent natural disasters will not be enough to right-size dealer inventories and absorb the swath of vehicles coming off lease. At the same time, competitive pressures generated by new technology and the slow sales environment, as well as low inflation expectations, will continue to weigh on firms ability and willingness to raise prices. That said, there is no shortage of sources that could knock inflation off our projected course for A stronger labor market is no guarantee of wage growth as we have seen in recent years, and even higher labor costs do not necessarily mean higher prices if margins are reduced. On the flip side, since the reasons behind inflation s more modest response to labor conditions are not well understood, there is the risk that the link reasserts itself more quickly than anticipated. 1 Throw in the potential for unusual weather, a collapse in trade agreements, other geopolitical crises and the typical noise in inflation data that can emerge from small sampling, and the inflation story could change dramatically in In this report, we focus on five specific inflation categories that have the potential to drive an inflation surprise next year. Our baseline forecast is for inflation to slowly strengthen over the course of the coming year. 1 Inflation, Uncertainty and Monetary Policy. Remarks by Janet L. Yellen, Chair of the Board of Governors of the Federal Reserve System. Sept. 26, This report is available on wellsfargo.com/economics and on Bloomberg WFRE.
2 Thousands Five Potential Inflation Surprises for 2018 Natural gas in storage is currently at the lowest level for this time of year since Inflator: Natural Gas From One Weather Extreme to Another Heading into the draw down season, natural gas in storage is currently at the lowest level for this time of year since 2014 (Figure 1). This alone would not be enough to generate higher heating costs in the coming months, but when combined with unusually cold temperatures this winter, prices could jump. The National Oceanic and Atmospheric Administration is predicting a percent chance of La Niña weather patterns this year, which would bring colder-than-average temperatures to the Northwest, Midwest and heavily populated Northeast. There has been no shortage of extreme weather lately. With the past two winters cracking the top 10 warmest on record, if this winter went from one extreme to the other, natural gas prices could soar like in early That winter was only the 29th coldest on record, but saw consumer prices for utility/piped gas services jump 16 percent between December 2013 and March (Figure 2). When combined with prices for electricity (for which natural gas is now the number one source), utility services had lifted the year-over-year rate of headline CPI by 0.3 percentage point by March. Figure 1 Figure Natural Gas in Underground Storage Trillions of Feet Squared, October Natural Gas Storage: 3.7K Energy Services Inflation Year-Over-Year Percent Change Electricity Services: 2. Utility Services: Source: U.S. Energy Information Administration, U.S Dept. of Labor and Wells Fargo Securities Prices for food away from home are especially sensitive to changes in minimum wages. 2. Inflator: Food Away From Home Not to Be Minimized The cost of dining out has grown more slowly over the past two years. The 12-month change in the CPI for food away from home, which carries a 5.8 percent weight in the index, has fallen by half a percentage point since mid-2016 (Figure 3). That slowdown is ripe for a reversal, however. Prices for food away from home are especially sensitive to changes in minimum wages given the high share of low-wage workers in the hospitality industry. In 2018, 20 states are scheduled to raise the minimum wage (Figure 4). That is slightly fewer than in 2017 (22), but recent research from the Boston Fed finds that inflation is raised by minimum wage hikes not only in the first year in which they go into effect, but also the following year. 3 While a growing number of states and cities have been raising the minimum wage in recent years, restaurants and other food prep establishments have gotten a respite from declining food costs. That breathing room could change in the coming year as food costs are beginning to rise again. The Commodity Research Bureau food index is up 6.8 percent over the past year, the largest increase since 2014 when more states began to raise the minimum wage. 2 Based on average temperatures from November to March since 1895, National Oceanic and Atmospheric Administration. 3 Cooper, Daniel, María José Luengo-Prado and Jonathan A. Parker. (2017). The Local Aggregate Effects of Minimum Wage Increases. Federal Reserve Bank of Boston Research Department Working Papers, 2017 Series,
3 Five Potential Inflation Surprises for 2018 Figure 3 Figure Food Spot Price vs. Food CPI Year-Over-Year Percent Change Food Spot Price: 6.8% (Left Axis) Food Away From Home CPI: 2. (Right Axis) $10.0 $9.0 $8.0 States Raising Minimum wage Dollars Per Hour vs. Number of States Number of States Raising Min. Wage: 22 Federal Min. Wage: $7.3 Emp. Weighted Avg. State Min. Wage: $ $ $ $ $ $ $ Source: U.S. Department of Labor, Bloomberg LP and Wells Fargo Securities 3. Inflator: Medical Care Healthy Inflation Again Medical care price growth has moderated somewhat in recent years amid efforts by insurers and the government to rein in costs (Figure 5). However, upward pressure from drug prices and labor costs could boost the CPI for medical goods and services in Prescription and over-the-counter drugs make up about 1.8 percent of the CPI consumption basket while medical services contribute 6.6 percent, giving them considerable weight in the overall CPI. As recently as September 2016, an upswing in medical goods and services contributed more than 43 basis points to year-over-year CPI inflation. Figure 5 Medical Care Inflation 3-Month Moving Average of Year-Over-Year Percent Change Goods CPI: 1. Services CPI: 1.8% Figure 6 Health Avg. Hourly Earnings & Jobs Openings Year-Over-Year Percent Change Healtchare Hrly Earnings: 2.9% (Left Axis) Health & Social Assist. Job Openings Rate: 5. (Right Axis) % Source: U.S Department of Labor and Wells Fargo Securities Fewer generic drugs are set to enter the market in 2018, which will likely push up prescription drug inflation. According to the PWC Health Research Institute, the sales value of drugs coming off patent protection declined by 32 percent in 2016 and 41 percent in 2017 from a year earlier. 4 Cost savings from generics usually show up 1-2 years after patent expiration, so the impact of fewer patent expirations in the past two years should be felt in Since generic alternatives cost percent less than branded drugs, their presence (or absence in this case) in the market can make a substantial difference to medical goods costs. Higher labor costs as the labor market continues to tighten are also likely to put upward pressure on medical care prices. More than half of the industry s input costs is employee compensation, and wage costs have been picking up over the past year. With the rate of job openings also trending Fewer generic drugs are set to enter the market in Medical Cost Trend: Behind the Numbers PwC Health Research Institute, June
4 Five Potential Inflation Surprises for 2018 We see a risk that multifamily developers have overbuilt. higher, we expect to see higher labor costs to put more upward pressure on the services component of medical inflation. 4. Deflator: Rent of Primary Residence The Affordability Wall Slower rent growth may be in the offing next year as the torrent of multifamily housing supply since the recession and eroding affordability collide. Shelter costs represent some of the largest slices of the CPI basket (altogether 30 percent), with rent of primary residences making up about 8 percent. Industry measures of apartment rent growth, which tend to lead the rent-of-primary-residence component of CPI, have slowed over the past year (Figure 7). We see a risk that developers overestimated the future strength of demand for multifamily properties and have overbuilt. Multifamily housing starts reached a level in February not seen since 1989, and higher vacancy rates point to the surge in supply outpacing demand. Homeownership rates have stabilized this year, helped by easier credit and low interest rates. At the same time, rent continues to grow faster than household income. The CPI for rent of primary residence rose 25 percent since the start of the expansion in 2009, but median household incomes have expanded 18 percent. Unlike the purchase market where financing terms can keep monthly payments in check, landlords may be unable to continue raising rents at the same pace until incomes catch up. Figure 7 Figure 8 Apartment Asking Rent vs. CPI Rent Year-over-Year Percent Change Apartment Asking Rent: 3.8% CPI Rent of Primary Residence: Multifamily Housing Starts SAAR, In Thousands, 3-Month Moving Average Multifamily Housing Starts: 319K Source: Reis, U.S. Department of Commerce, U.S. Department of Labor and Wells Fargo Securities Hotel occupancy rates have declined slightly in 2017 after peaking in Q Deflator: Lodging Away from Home Hotel Headaches Growth rates in the CPI for lodging away from home have already moderated this year. However, there is scope for a more dramatic fall if a mismatch between hotel supply and demand pulls down occupancy further, and hotel managers respond with substantially lower rates. Hotel occupancy rates have declined slightly in 2017 after peaking in Q (Figure 9). Vacancies put pressure on room rates as hotels compete for customers with discounting and special offers; real room rates fell year-over-year in Q3 for the first time since Q on a seasonally adjusted basis. While the weight of lodging away from home in the CPI is small just 0.9 percent changes in this component have moved the headline by as much as 8 basis points in recent years, and when combined with other factors can make a palpable difference to inflation. An uptick in the number of hotel rooms in planning or construction phases this year suggests that hotel occupancy may continue to be a challenge in 2018, as new supply outpaces demand. Rooms in the pipeline as a share of existing supply were up 1.4 percentage points in October compared to January 2016 (Figure 10). Given an average construction lead time of eight months for private nonresidential projects, these hotel rooms will likely feed into supply early next year. Services such as Airbnb are also providing lodging alternatives to traditional hotels and increasing competition for attracting customers. 4
5 Five Potential Inflation Surprises for 2018 Figure 9 68% 6 6 Hotel Occupancy Rate Seasonlly Adjusted, Percent 68% 6 6 Figure Hotel Rooms in Planning and Construction Percent of Existing Supply Secondary Markets Top 25 Markets % 8.3 8% 58% 58% Average Occupancy ( ): 62. Occupancy: Jan-2016 Oct-2017 Source: Bloomberg LP, Smith Travel Research and Wells Fargo Securities Meanwhile, macroeconomic factors are not supportive of sizable increases in hotel demand in the near future. Corporate profit growth is expected to be in only the low-single digits next year, limiting growth in business travel. Meanwhile, modest growth in disposable income is also holding back growth in leisure travel. U.S. air travel shrank this year, with passenger enplanements down 2.9 percent year-to-date compared to Given our forecast for modest corporate profit and disposable income growth into next year, we expect continued softness in travel activity and associated hotel demand. Conclusion Inflation is notorious for being knocked around by a few categories. While inflation watchers are accustomed to the volatility caused by food and gasoline prices, this year was a reminder that other categories that are typically more stable and/or smaller can have meaningful effects on aggregate price movements. We are watching a number of categories that could similarly upset our baseline forecast of moderately stronger inflation next year. These items, however, offer the potential of both upside and downside pressure. As a result, we see the risks these categories present to our forecast as roughly balanced. 5
6 Wells Fargo Securities Economics Group Diane Schumaker-Krieg Global Head of Research, Economics & Strategy (704) (212) John E. Silvia, Ph.D. Chief Economist (704) Mark Vitner Senior Economist (704) Jay H. Bryson, Ph.D. Global Economist (704) Sam Bullard Senior Economist (704) Nick Bennenbroek Currency Strategist (212) Eugenio J. Alemán, Ph.D. Senior Economist (704) Azhar Iqbal Econometrician (704) Tim Quinlan Senior Economist (704) Eric Viloria, CFA Currency Strategist (212) Sarah House Economist (704) Michael A. Brown Economist (704) Jamie Feik Economist (704) Erik Nelson Currency Strategist (212) Michael Pugliese Economic Analyst (704) E. Harry Pershing Economic Analyst (704) Hank Carmichael Economic Analyst (704) Ariana Vaisey Economic Analyst (704) Abigail Kinnaman Economic Analyst (704) Shannon Seery Economic Analyst (704) Donna LaFleur Executive Assistant (704) Dawne Howes Administrative Assistant (704) Wells Fargo Securities Economics Group publications are produced by Wells Fargo Securities, LLC, a U.S. broker-dealer registered with the U.S. Securities and Exchange Commission, the Financial Industry Regulatory Authority, and the Securities Investor Protection Corp. Wells Fargo Securities, LLC, distributes these publications directly and through subsidiaries including, but not limited to, Wells Fargo & Company, Wells Fargo Bank N.A., Wells Fargo Clearing Services, LLC, Wells Fargo Securities International Limited, Wells Fargo Securities Asia Limited and Wells Fargo Securities (Japan) Co. Limited. Wells Fargo Securities, LLC. is registered with the Commodities Futures Trading Commission as a futures commission merchant and is a member in good standing of the National Futures Association. Wells Fargo Bank, N.A. is registered with the Commodities Futures Trading Commission as a swap dealer and is a member in good standing of the National Futures Association. Wells Fargo Securities, LLC. and Wells Fargo Bank, N.A. are generally engaged in the trading of futures and derivative products, any of which may be discussed within this publication. Wells Fargo Securities, LLC does not compensate its research analysts based on specific investment banking transactions. Wells Fargo Securities, LLC s research analysts receive compensation that is based upon and impacted by the overall profitability and revenue of the firm which includes, but is not limited to investment banking revenue. The information and opinions herein are for general information use only. Wells Fargo Securities, LLC does not guarantee their accuracy or completeness, nor does Wells Fargo Securities, LLC assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. Wells Fargo Securities, LLC is a separate legal entity and distinct from affiliated banks and is a wholly owned subsidiary of Wells Fargo & Company 2017 Wells Fargo Securities, LLC. Important Information for Non-U.S. Recipients For recipients in the EEA, this report is distributed by Wells Fargo Securities International Limited ("WFSIL"). WFSIL is a U.K. incorporated investment firm authorized and regulated by the Financial Conduct Authority. The content of this report has been approved by WFSIL a regulated person under the Act. For purposes of the U.K. Financial Conduct Authority s rules, this report constitutes impartial investment research. WFSIL does not deal with retail clients as defined in the Markets in Financial Instruments Directive The FCA rules made under the Financial Services and Markets Act 2000 for the protection of retail clients will therefore not apply, nor will the Financial Services Compensation Scheme be available. This report is not intended for, and should not be relied upon by, retail clients. This document and any other materials accompanying this document (collectively, the "Materials") are provided for general informational purposes only. SECURITIES: NOT FDIC-INSURED/NOT BANK-GUARANTEED/MAY LOSE VALUE
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