Jim O'Sullivan - High Frequency Economics

Q&A with Jim O’Sullivan on the U.S. inflation outlook

HFE’s Chief U.S. Economist Jim O’Sullivan answers questions about the outlook for wages, inflation and Fed tightening this year and next.

Jim O'Sullivan - High Frequency Economics

Why haven’t wages picked up? Is the Phillips curve/NAIRU framework outmoded?

The correct framework has wages and inflation only picking up significantly when the unemployment rate drops below the NAIRU, and that just happened in the past year. Meanwhile, through the volatility, wage gains have started to accelerate. We expect that uptrend to continue.

As Fed Chair Greenspan used to say regularly, “The laws of supply and demand have not been repealed.”


What about core inflation?

I admit to less conviction about acceleration in core inflation in the year ahead, as many factors other than slack can affect the data, particularly in the short run. Also, with inflation expectations “well-anchored,” the NAIRU framework implies only gradual acceleration.

Over time, however, a pick-up in wage costs is likely to be mirrored in output prices as well. That acceleration will continue, even after the unemployment rate finally stops falling. That is why the Fed needs to stop the downtrend in the unemployment rate ASAP.

Do you think markets are pricing in enough Fed tightening?

Regarding 2018, markets still have a ways to go, and if so bond yields are likely to rise some more. Even a modest pick-up in inflation, along with a continued downtrend in the unemployment rate, will be enough to keep the Fed on its quarter-point-per-quarter path. Remember, if one counts the QT announcement as a move, as one should, the Fed has moved at each of the last five end-of-quarter meetings.

Regarding 2019, market pricing seems to imply that another two to three tightenings this year will be enough to stop the downtrend in the unemployment rate, and that wages and inflation will not keep moving up once the unemployment rate stops falling. We are skeptical it will be that easy, even after allowing for neutral rates being somewhat lower than in the past. Moreover, the low funds rate will continue to be supplemented by stimulus from the still-large Fed balance sheet. That stimulus will decline as the balance sheet shrinks, but it is likely to remain significant for a while.

What if equities tumble?

In that case, the Fed would not have to tighten as much. Other things equal, the more stimulus from financial conditions, the more need there will be for the Fed to raise rates. We don’t expect the surge in equities to continue, but we are assuming no significant weakening any time soon, either.

There has been some talk of Fed officials changing their 2% inflation goal. Can you see that happening any time soon?

No! While there might be an argument for going for slightly higher inflation if they were starting fresh, any change now would likely make anything they say about their goals going forward less credible. Plus, such a change would lead to major objections from Congress: The Fed is mandated by Congress to try to achieve “stable prices” and “maximum employment,” and even the 2% figure is probably a bit high for some “hard-money” Republicans.

More plausible is the possibility that the Fed tweaks its policies relating to how the 2% inflation objective is interpreted. However, that shift would likely be preceded by a long period of study, starting with a subcommittee of officials producing recommendations, and then the full FOMC debating the recommendations over the course of many meetings. Also, any changes would likely only be relevant for the next easing cycle, which we don’t anticipate for a while.

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