BNP Paribas AM: US inflation outlook - The rising tide

Since January, our outlook on US growth and inflation prospects has become more constructive. We have lifted our targets for both US Treasury yields and TIPS-based breakeven inflation rates (BEI).

Looking first at growth, the additional budget measures signed in February are set to add an additional $300 billion of deficit-funded spending to the economy over the next two years, on top of the $1.5 trillion of deficits that will be created over the next decade as a result of December’s ‘Tax Cut and Jobs Act’. Although a portion of the budget measures represent funding for assistance to regions that were devastated by last fall’s hurricanes, a significant portion of this spending package is essentially discretionary. To our mind, engaging in such fiscal largesse at a point in the economic cycle when authorities ought to be reducing rather than adding to the national debt is, frankly, irresponsible. Regardless, most analysts anticipate that these spending measures will contribute 0.5 percentage points to gross domestic product (GDP) growth in both 2018 and 2019.

In addition, growth is likely to be supported by ongoing robust business investment. Certainly, the recent corporate tax cuts, and changes to tax-expensing of capital investment have boosted firms’ investment plans. Additionally, whereas much of the contribution of business investment to GDP in 2017 was concentrated in the resources and mining sectors (in response to rising commodities prices), in 2018 we expect to see increasing breadth in the distribution of investment across sectors.

Correspondingly we have raised our GDP growth forecasts for 2018 and 2019 to 2.9% and 2.5%, respectively. With trend GDP growth probably still languishing in the 1.5% to 2.0% range, this implies that we will see further compression in spare capacity in goods and labor markets. Indeed, we expect non-farm payrolls to continue growing at a pace exceeding the replacement rate, helping to drive the unemployment rate towards 3.5%. Our view is that spare capacity in the labor market will soon be exhausted, notwithstanding the failure of prime-age male participation to fully recover. As such, wages seem set to continue rising, even if we do not forecast a rapid acceleration.

With labor compensation data likely to show improvement in coming months, we expect the Federal Reserve (Fed) will grow increasingly confident in its assessment that underlying inflation is returning to target, and that the softness exhibited in core consumer price index (CPI) and personal consumption expenditures (PCE) data in 2017 reflected a mix of transitory factors (notably declines in cell-phone plan prices) and ‘acyclical’ factors (compression of medical care prices as a result of the Affordable Care Act).

Since January, we have received two more CPI prints (for December and January). Both data releases have revealed a gentle firming of core inflation, with strength in shelter costs (via rents and owner’s equivalent rent), vehicle prices and medical care. In January, CPI was also supported by a bounce in apparel prices after several months of decline.

Please click here to read the full note.