Inflation may be starting to fire up and the Federal Reserve’s credibility could get burned.
Just days after policy makers softened their outlook for the pace of interest-rate increases, evidence has accumulated that prices are beginning to move higher.
If that trend continues, it could fray investors’ confidence that price pressures remain in check, or lead them to conclude that this is a deliberate effort by the Fed to test the 2 percent target to ensure the US economy remains durable despite weakness and deflationary forces abroad.
Exhibit A: Both longer-run survey and market measures of inflation expectations are starting to recover, after dipping during the market turmoil of last the last few months.
Oil prices, whose collapse since mid-2014 are blamed for holding inflation well below the Fed’s 2 percent target, hit a three-month high after the March 15-16 meeting of the U.S. central bank. Officials at that meeting held their target for the benchmark federal funds rate steady at 0.25 percent to 0.5 percent, while halving the number of times they expect to hike this year from four moves projected in December. Oil prices are currently trading around $40 per barrel, or more than 50 percent higher from their Feb. 11 low of $26.21 per barrel.
In addition, measures of core inflation, which strip out food and energy prices, have also shown a decisive upswing that the Fed could struggle to explain away.
“They are going to have a communications challenge,” said Ethan Harris, co-head of global economic research at Bank of America in New York. “Can you only raise interest rates twice this year if core inflation is steadily accelerating?”
U.S. central bankers gave a lot of weight to global risks while keeping their estimates for core inflation unchanged at 1.6 percent for the final quarter of this year, according to their median estimate for the personal consumption expenditures price index released on Wednesday. Trouble is, core PCE was already 1.7 percent higher for the year ending January.
The risk for investors relying on the Fed’s shallower rate-hike projection is that officials could switch their message suddenly if inflation data comes in stronger than expected, leading them to raise rates at a faster pace.
“The breadth of gains over the last few reports suggests price pressures are broadening out,” said Omair Sharif, an interest-rate strategist at SG Americas Securities LLC in New York. “They are really trying to thread the needle: the data is firm but the message is we can continue to be patient.”
Another gauge of price pressures, the year-over-year rate on the consumer price index minus food and energy, has advanced one-tenth of a percent every month since October, hitting a pace of 2.3 percent in February. Chair Janet Yellen in her press conference was dismissive, saying the committee hasn’t “yet concluded that we have seen any significant uptick that will be lasting in, for example, in core inflation.”
Yellen may have been referring to cyclical components — apparel, airfares, lodging, and new and used vehicles — when she spoke of possible “transitory factors” giving inflation a temporary lift, according to Sharif. Those items had been weighing on inflation until January and February, when they made large contributions to overall price increases.
Sharif said it is unlikely that the big gains in volatile CPI components, such as apparel, will continue. Still, gauges designed to filter out that sort of noise in the data by concentrating on slow-moving prices, such as food consumed away from home and car repairs, are also rising. The Atlanta Fed’s sticky CPI measure has shown gains every month since May.
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Richmond Fed President Jeffrey Lacker, a policy hawk who dissented in September and October in favor of an earlier liftoff of interest rates from zero, said Monday in Paris that headline inflation could “move significantly higher” when oil prices bottom out.
Atlanta Fed President Dennis Lockhart later said that while a rate rise could be justified as early as the next FOMC meeting on April 26-27, policy makers were paying attention to the downward drift on inflation expectations in the second half of last year, though “obviously we’ve been encouraged by the recent reversal.”
When the policy-setting Federal Open Market Committee raised rates in December for the first time in nearly a decade, it said it was looking for “actual and expected” progress toward its inflation goal as it considers future moves. Despite the gains in inflation, investors have embraced the Fed’s go-slow message and place a higher probability of only one rate hike this year instead of two, according to pricing in interest-rate futures.
Run It Hot
Based on their forecasts this month, the FOMC projects unemployment below their estimate for full employment while raising rates gradually. That suggests a strategy of “a high pressure economy,” and some “tolerance for overshooting the 2 percent” inflation target, said Laurence Meyer, a former Fed governor and president of LH Meyer Inc. in Washington.
Yellen in her March 16 press conference said the Fed wasn’t trying to overshoot the target, though some overshoots are “part of how the economy operates.”
Harris, in a note to clients, said the FOMC appears to be intentionally risking an overshoot because there is a “very strong economic case” for doing so. The Fed has been below its inflation target for approaching four years.
Slightly higher inflation would allow the central bank to gradually push interest rates further above zero — giving them more policy firepower if they have to cut them again if the U.S. economy faltered.
“We’re still in a world of very unbalanced risks,” Harris said. “The Fed is close to the zero boundary, the global economy is weak, and overshooting on inflation is a minor problem.”
(Updtes with comments from Fed’s Lockhart in 15th paragraph.)
–With assistance from Matthew Boesler To contact the reporter on this story: Craig Torres in Washington at firstname.lastname@example.org. To contact the editors responsible for this story: Carlos Torres at email@example.com, Alister Bull, Brendan Murray
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