Core inflation above target; not to worry?

The commentary that follows is by Scott Grannis, Chief Economist at Western Asset Management.
-- David M Gordon / The Deipnosophist
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The bond market is dominated these days by the belief that the housing downturn that began a year ago will slow the economy by enough to reverse the otherwise troublesome increase in core inflation that we have seen over the past two years. So much so, in fact, that at least two Fed easings are expected next year. This belief rests on two key assumptions, however, both of which are not necessarily slam-dunks: Will the housing downturn slow the economy by enough to make a difference? And if the economy slows, will that bring inflation down?

To date he have yet to see convincing evidence of slower overall growth. There's been the odd sign of of weakness, in particular the Philly Fed index, which a few weeks ago dropped unexpectedly (but only to a low that it also hit in June of last year, when the economy was quite healthy overall). But there have been the odd signs of strength as well, such as today's release of the Chicago ISM index, which jumped unexpectedly to its highest level in over a year.

From a broader perspective, the news actually looks pretty decent: Weekly claims for unemployment show no signs of turning up, even though building permits nationwide have dropped 22% from January through August (if residential contractors are laying off people, maybe nonresidential contractors are snatching them up). The Challenger survey of layoff announcements has dropped 40% so far this year. Federal and state tax revenues continue to exceed expectations (strong tax payments reflect strong income growth and capital gains realizations). The Dow is at a new all-time high, and corporate profits relative to GDP have never been so strong (companies are about to launch massive layoffs at a time when profits are gushing?). Swap spreads show no signs of the rising systemic risk that has preceded significant economic downturns in the past, and high-yield spreads are close to their all-time lows. Atlantic freight rates are up 70% so far this year, and industrial commodity prices are within inches of their all-time highs (i.e., the global economy remains strong). If almost five years of rising energy prices have been a drag on growth, it's good news that oil and gasoline have reversed all of the price hikes of the past year, and natural gas is back to 2003 levels. And if higher mortgage rates proved to be the tipping point for the housing market, it is worth noting that rates have already reversed almost half of their rise from last summer's lows.

Apart from a predictable downturn in headline inflation that results from a sharp drop in energy prices, we haven't seen any evidence that inflation in general is cooling. Indeed, the fact that core measures of inflation have been rising for the past three years suggests that monetary policy to date has effectively accommodated higher energy prices, allowing them to find their way into other prices. If the Fed had been tight, higher energy prices would at the very least have resulted in nonenergy inflation falling, not rising. Gold prices have tended to be a good indicator of broad inflation trends, and gold today is about 30% higher than it was a year ago, and 60% higher than it was three years ago. Big downturns in the economy and inflation have typically been preceded by a significant increase in real yields (i.e., a major tightening of monetary policy), yet the real yield on the Fed funds rate is only about 2%, and the ex-post real yield on 10-year Treasuries is less than 1%.

We may yet see a weaker housing market eat away at the foundations of the broader economy, and we may yet see inflation fall with little or no help from the Fed, but these are still big ifs that the bond market seems to be ignoring.

Caveat emptor, as they say.