After a comatose decade, the Federal Reserve fastened its pace of policy normalisation. It lifted its benchmark federal funds rate twice in the first half of 2017 alone, ranging between 1% and 1.25% now, and pencilled in another one, or possibly two rises this year. But the numbers did not follow the path officials at the Fed wish it had.
After touching the 2% inflation target in the first quarter of the year, the Fed’s preferred inflation measure, the core personal consumption expenditure (PCE) barely nudged in April and May amid uncertainty in Washington and fierce competition among wireless services providers.
On several occasions, the Fed Chairwoman Janet Yellen described this slowdown in inflation as “transitory”, and hinted that the central bank was unlikely to stop its plan of further rate hikes. Meanwhile, she also acknowledged that current deceleration in inflation was not expected by the officials, especially given the tight labour market. So what is wrong here? To answer the question, one must first determine whether the ongoing slowdown in the price levels is really transitory.
The following graph from the Department of Commerce depicts the trend in inflation in the past five years. Housing, which generally has the highest weight when calculating PCE, witnesses a gradual increase in price level until the beginning of 2017 due to a strong demand in the market resulting from lower rates, higher home equity and demographic development.
However, the ebb of the current accommodating monetary policy may discourage people from flocking to the housing market when mortgage rates rise, and banks gingerly watch their loan growth. Whether recent price slowdown in the market is a harbinger of a new era is open to debate; but given the momentum of current economic expansion, home price inflation is likely to dip beyond the near future.
Development in price levels in pharmaceuticals and healthcare depends as much on policy agendas in Washington as it does on the industry’s fundamentals. The broader implementation of Obamacare in 2014 and the Democratic Party’s indefatigable diatribe of medicine companies in the past three years created headwinds for the industry’s price level.
Though business-friendly GOP now controls both chambers of the Congress and the White House, recent ordeals in trying to dismantle Obamacare just demonstrate the unremitting uncertainty faced by the industry. The path of the price level is therefore difficult to chart with confidence.
Effects of Technology
Furthermore, technological development may take its toll on the industry as well. Though America’s ageing population may boost price levels in pharmaceuticals and healthcare, adoption of big data and artificial intelligence has the potential to subdue the effect and create long-term headwinds for the industry. Although it is hard to tell if current delay in price inflation is permanent, the trend in housing, pharmaceuticals and healthcare – three of the biggest individual contributors to PCE – suggests it to be at least non-transitory.
Figure 1. Slowing Down
Recalling the 1970s
The Fed previously blamed price competition in wireless services and a drop in prescription drug bills for the slowdown in the overall price level, and believed in the tight labour market to turbocharge the inflation. America has not enjoyed such a tight labour market since the dot-com bubble, but wage growth remains subdued relative to history standards for a prolonged period. The statistical relationship between unemployment and inflation seems to break down (see Figure 2). This relationship and its variants are the so-called Phillips curve.
Phillips’ original argument is in terms of wage growth and unemployment. When labour market is tight and unemployment is low, ceteris paribus, wage grows faster than otherwise, and so follows the PCE/inflation. Thus, Phillips curve essentially gives policymakers a chance to choose from high inflation with low unemployment, or low inflation with high unemployment. However, the theory backfired when the U.S. experienced both high inflation and high unemployment in 1970s. The theory then underwent major modifications to become what we know of today – the expectations-augmented Phillips curve that underpins the theoretical foundation of nearly all major central banks, including the Fed.
Figure 2. Breaking Down
Why is the economy not giving the price level the Fed wants? Consumers’ sustained risk aversion and reluctance to spend after the most damaging financial crisis since the Great Depression may explain part of the story. But any attempt to fully answer this question may engender even more problems than solutions.
New Keynesian Phillips Curve
The key theory behind the model the Fed uses to make economic forecasts is the New Keynesian Phillips curve (NKPC) in the presence of nonzero trend inflation developed in Cogley and Sbordone (2008). It is a modification of the aforementioned expectations-augmented Phillips curve, and constitutes the foundation of price and wage setting modelling in the Fed’s methodology of economic analysis.
This theory features monopolistic competition and staggered price setting, in a sense that at any time t, only a fraction of firms can reset their prices optimally when faced with a shock to the economy. This assumption is becoming increasingly untenable, given the potential disruptions technological advance can bring. Unlike traditional companies in manufacturing and services, information technology companies such as FAANG (Facebook, Apple, Amazon, Netflix and Google) enjoy near perfect monopoly in their respective lines of business.
Consolidation vs Competition
Consolidation, not competition is driving the growth of the industry. Google and Facebook are taking the bulk of online advertising that price influence from other firms is negligible. There is barely staggered price setting because all players (only two, in the online advertising case) can reset their optimal price almost at once, generating limited and foreseeable price inflation.
With the penetration of big data and artificial intelligence that discover and seize opportunities even before they manifest, industries other than information technology that once flocked with Luddites are becoming progressively consolidated and monopolistic. Price setting and expectations of future inflation are no longer gradual but abrupt, inconspicuous and restrained.
Assumptions of NKPC have not reflected this change. Therefore, the reason why inflation has not picked up given a tight labour market is likely not because a certain industry is creating transitory headwinds for price levels, but because the economy is witnessing a fundamental transformation of how major industries are implementing their price setting process.