The Bureau of Labor Statistics reported that a measure of inflation, its Consumer Price Index – Urban Consumer (CPI), rose by 2.1 percent over the past 12 months, similar to the 12-month rate of growth recorded in December. Meanwhile, core inflation, which excludes the more volatile energy and food prices, rose by 1.8 percent, also matching its growth rate in December. January marks the 9th consecutive month that core CPI has registered a growth rate of 1.7 or 1.8 percent.
Over the month, headline consumer price growth was 0.5 percent. Due to its large monthly growth rate, energy prices accounted for 0.23 percentage points of the 0.5 percent month-over-month growth in the CPI. Meanwhile, due to its size, core CPI accounted for 0.24 percentage points. However, the 0.3 percent monthly growth in core CPI is its largest month-over-month growth rate since January 2017. Annualized over the past 3 months, core CPI reached 2.9 percent, its highest rate since 2011.
While inflation is an important component of U.S. Treasury rates, the real, or inflation-adjusted, return is the primary reason for the longer-term rate decline. Analysis suggests that the decline in the real yield is primarily related to a slowdown in the growth of the economy’s potential.
The table above compares the major components of the CPI between December and January. Headline inflation recorded a significant acceleration in growth, from 0.2 percent to 0.5 percent. Over the month of December, energy prices fell and subtracted .02 percentage point from the growth of headline CPI. In contrast, core CPI rose and accounted for the majority of the 0.2 percent monthly increase in the CPI.
The 0.3 percentage point increase in headline CPI between December and January largely reflected the 0.25 percentage point higher contribution from energy prices as they swung from a decline in December to an increase in January.
Much attention has been paid to the most recent growth in average hourly earnings. Previous NAHB analysis noted that it was the highest rate of growth since the end of the Great Recession, but at 2.9 percent, it remains below growth rates that prevailed prior to the downturn.
Growth in average hourly earnings is important for interest rates because it is positively related to inflation, as higher earnings growth tends to spark faster inflation. Compensation for inflation, a measure of inflation expectations, is a component of U.S. Treasury rates.
One reason why earnings may rise is because the unemployment rate is low. The unemployment rate is considered low, not just on a historical basis, but also relative to its natural rate, which is an unemployment rate that neither stokes nor dampens inflation. As the figure above shows (using a CBO estimate of the natural rate), the location of the actual unemployment rate relative to its natural rate is inversely, but weakly related to growth in average hourly earnings.
Although inflation compensation, which has returned as an accurate measure of inflation expectations, plays a key role in the recent rise in longer-term rates, an earlier post illustrated that the primary reason for the longer decline in the 10-Year Treasury note rate is the real, or inflation-adjusted, yield, as measured by the rate on 10-Year Treasury Inflated Protected Securities. That post illustrated the role played by the Fed’s actual bond buying on the trajectory of the real yield while an earlier post showed how the Fed’s communication about its balance sheet intentions in 2013 also influenced the performance of the real yield.
While the Fed has affected the real yield, the bigger impact has come from the marked slowdown in the economy’s potential growth. An earlier post illustrated how the real yield is a reasonable proxy for r*, which measures the underlying strength of the economy, and r* has generally tracked the four-quarter growth rate of the economy’s potential.
Using information on potential GDP and its components provided by the Congressional Budget Office indicates that the recent slowdown in the growth rate of potential GDP reflects deceleration in potential productivity. At the same time, the growth of the potential labor force has been slowing since reaching a peak in 1972. Its deceleration between 1972 and 1999 was offset by a broad acceleration in potential productivity of the labor force during these years. Although the growth of the economy’s potential remains low, between 2010 and 2015 it has accelerated, reflecting both an acceleration in productivity and the labor force. The slowdown in growth of the economy’s potential in 2016 reflected a deceleration in the growth of the potential labor force. However, the growth of economy’s potential remains above its 2010 low. This suggests that as balance sheet normalization continues, the real yield should further approach the slightly higher rate of the economy’s potential growth.