How confident are you of on-target US inflation and an H1 rate hike?

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Overall, the minutes of the December meeting of the Federal Open Market Committee (FOMC) portray a Committee that remains quite upbeat about the prospects for the US labor market and GDP growth over the medium term. As at the October meeting, members highlighted diminishing labor market slack, robust household spending in some parts of the US, and very supportive business conditions.

DOWNSIDE RISKS FROM ABROAD, ROBUST GROWTH AT HOME
Still, underneath the surface there appears to be a bit more focus on downside risks to growth stemming from the global outlook. In fact, the Committee singled out international developments as the largest downside risk to the US outlook, and noted the risks associated with potentially insufficient foreign policy responses. However, the change in tone on global risks is not particularly strong compared to the September and October minutes, and has few policy implications at present.

While global developments may present downside risks, Committee participants viewed them as “nearly balanced” by the prospects of an acceleration in growth momentum given high levels of business and consumer confidence, strong payrolls growth, and the likely boost to spending as a result of lower energy prices.

INFLATION: “REASONABLY CONFIDENT” OF RETURN TO 2%
Discussion regarding inflation risks appears to have evolved a bit since the prior meeting, which is not surprising given the collapse in market-based measures of inflation compensation and new statement language introduced in December indicating that the Committee “continues to monitor inflation developments closely”.

The minutes note that a “number” of participants see risks that inflation could remain persistently below the Committee’s 2% objective, and others commented that the decline in market-based measures of inflation compensation might indicate that long-term inflation expectations have de-anchored somewhat. But the overall view of the Committee remains that recent declines in inflation readings should ultimately prove transitory, and therefore should not stand in the way of rate normalization so long as the Committee remained “reasonably confident” that inflation would move back to 2% over time.

INTEREST-RATE NORMALIZATION ON A SHALLOWER PATH
Given this discussion it is appropriate to consider whether the Committee’s confidence in inflation returning to the objective has diminished as of late. Recall that compared to the September Summary of Economic Projections, the Committee’s December projections revealed quicker convergence of the unemployment rate to NAIRU, but a notably shallower interest-rate path. This may seem inconsistent on the surface, but can be explained by Committee participants’ sharp downward revision to their PCE inflation projections: for year-end 2015, the mid-point of the central tendency for PCE inflation declined to 1.30%, from 1.75% in the prior projection round.

Thus the Committee now projects a longer period of below-objective inflation. As seen in the chart below, the gap between projected inflation one and two years forward (i.e., between year-end 2015 and 2016) is the largest it has been over the past five years. Meanwhile, the Committee’s success in forecasting inflation two years hence is quite weak: since 2008, the absolute average forecast miss, based on the mid-point of SEP projections, has been half a percentage point.

US rate hike

FACTORS THAT COULD DELAY A RATE HIKE
In short, there is quite a bit riding on the Committee remaining confident in inflation returning to target over the next few years. While I still see liftoff occurring in June of this year, some combination of continued US dollar strength, further declines in realized or expected inflation, and a deterioration in the global growth outlook could push the first rate increase into the second half of the year.

Steven Friedman

Senior Investment Strategist

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