Why inflation doesn’t signal a strong economy

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Acyclical factors, not a strong economy, may be responsible for core personal consumption expenditures (PCE) price index inflation reaching the Fed’s 2% target in July, according to a Federal Reserve Bank of San Francisco researcher.

And as a result, “there is a considerable possibility that inflation will fall below the FOMC’s 2% target,” Adam Shapiro, a research advisor in the Bank’s Economic Research Department, wrote in an Economic Letter released Monday.

“While cyclical inflation is low compared with the level suggested by standard Phillips curve theories in relation to the very low unemployment rate, inflation rates in non-health acyclical categories are currently high compared with benchmark levels,” Shapiro wrote. “This implies that the recent upward pressure stemming from acyclical factors could diminish in the future.”

Acyclical factors are “idiosyncratic,” as opposed to cyclical factors, which are “more likely to be driven by overall economic conditions and hence is more sensitive to monetary policy.” Cyclical inflation held “fairly steady” in the past year and remains lower than would be surmised “given the very tight labor market,” he writes.

“By contrast, the portion of acyclical sectors that do not include health services (non-health acyclical inflation) is currently experiencing relatively high inflation,” Shapiro noted. “If non-health acyclical inflation were to revert to more normal historical levels, it would imply some downside risk that future inflation would fall below target again. Overall, the analysis shows the risks to the inflation outlook are balanced between a potential rise or fall. However, a considerable possibility remains that inflation has not yet sustainably reached target.”

While acyclical inflation has increased “about 0.5 percentage point” from a year ago, “cyclical inflation rose steadily coming out of the recession, as would be expected in a Phillips curve framework; however, the series has been flat more recently,” Shapiro wrote. “That is, cyclical inflation has not risen with the continued strengthening in the economy over the past year.”

Included in the idiosyncratic rises, Shapiro mentioned: cellular telephone services, and financial service charges and fees, including “charges for deposit accounts, credit card services, and automatic teller machines,” which made up almost “half of the increase in acyclical inflation over the past year.”

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Inflation Federal Reserve Bank of San Francisco