Inflated worries, part 1 - an overview of US inflation pressures Here's a rough sketch of the variables influencing US inflation, which has been remarkably low for two years running: 1) The remaining labour market slack, including a staggering and resilient long-term unemployment problem. The amount of slack remains tough to know given the difficulty of measuring the cyclical vs secular components of the fall in the labour force participation rate. Much more on this later. 2) The output gap. This isn't a well-defined idea, we know, but few people would argue that the US economy is producing at potential. The US economic recovery does appear to have accelerated in the final two quarters of last year (the December jobs report notwithstanding), and the conditions for growth look better than they have in years. If the nascent acceleration proves sustainable, then the labour market may well tighten up and push wages higher. Obviously this is related to the first point about labour market slack, and plenty of caveats are needed given the head-fakes of the last four winters. 3) The ongoing positive supply-side shock to the US energy landscape, coupled with soft commodity prices generally. Commodity prices can, of course, turn quickly, in which case both food and energy inflation could begin to accelerate. But the correlation between energy and non-energy inflation has become negligible. And although energy inflation still obviously affects the headline number, the declining correlation does represent a good reason to downplay energy price swings in setting policy. 4) A slowdown in medical prices because of a reduction in Medicare reimbursements. The part of the Medicare reimbursement reduction that resulted from sequestration cuts will normalise this year, but this will only reverse some of the decline in core PCE growth. The other part, which was designed by the Affordable Care Act (Obamacare) to be an ongoing reduction in the annual rate of increase in Medicare payments, will remain in place, though the reductions may affect inflation less this year than last. 5) Shelter inflation has increased in recent months. It seems likely to keep climbing. Shelter inflation typically lags changes in home prices, mortgage rates and vacancy rates - the trends of which last year would point to a continued pickup. But some of this might also be offset by the supply-side response in housing construction, especially in multi-family housing, dampening rents. It's also worth remembering that in the Fed's preferred measure of inflation, the PCE price index, shelter accounts for only 15 per cent of overall inflation, roughly half the weight it gets in the CPI. When there are gaps between the two, it is CPI that generally tends to adjust in the direction of PCE. 6a) A slowdown in emerging-market growth last year with an uncertain forecast for this year. Notably for China, plus there's the ongoing worry of a currency or financial crisis in Argentina, Turkey, South Africa, Indonesia, etc. Though some economists would add that the growth slowdown started to reverse in the middle of last year, with the potential for a slightly higher aggregate growth rate this year. 6b) Demographic pressures of aging populations across the developed world. And despite some encouraging signs recently, slow growth is expected in both Europe and Japan this year. Regarding the importance of inflation trends abroad being imported into the US, this is a surprisingly unsettled topic. The BIS thinks global inflation pressures matter a lot for US inflation; Fed staff economists and Goldman Sachs have disagreed. Combined imports and exports add up to slightly less than a third of US GDP, and therefore the country is less sensitive to global price fluctuations than more-open, smaller economies. But at the very least, given what's happening in emerging markets and the tepid growth outlooks for advanced economies, we can say that such fluctuations are unlikely to be significantly inflationary. In economic forecasting, the best anyone can do is make imprecise estimates based on incomplete information. It's better to think in terms of present conditions than to anticipate the future with any degree of certainty. With that in mind, the conditions seem to be in place for US inflation to be moderately higher this year than it was last year. Taken in its entirety, however, the list of factors influencing prices also suggests a benign situation - that is, a situation where it is very unlikely that the Fed will lose control and prices spike suddenly at an alarming rate. And if a rise in headline inflation is driven mainly by non-core variables, then the recent past would suggest that the Fed should downplay its importance, at least for a while. Things get more complicated, of course, if inflation shoots up unexpectedly on account of the economy's strengthening - if, for instance, the labour market was tighter than anticipated, suddenly pushing wages higher. We'll discuss this in part 2.