The Fed Brushes Off Low Inflation and Keeps on Going

The recent FOMC meeting concluded, as expected, with another rate hike of 25 basis points; the rate was pushed up to the 1%-1.25% range. This decision came on the heels of the latest CPI report, in which both core and headline CPI came below expectations: The headline CPI reached an annual rate of 1.9% — a 0.1% drop month over month – and the core CPI sans food and energy was only 1.7%. Moreover, retail sales dropped by 0.3%, month over month.

The Fed basically didn’t let the data stop them from continuing their normalization process. Considering the economy is still doing well – albeit not great – and GDP growth is still expected to pick up in Q2, according to GDP Now it’s expected to come at 3.2%. Therefore, this decision, while doesn’t seem to be based on the current data, isn’t likely to tip the U.S. economy into a slowdown.

In terms of the dot plot, the Fed didn’t make any major changes; and as for its economic outlook, the members revised down their estimates on inflation and unemployment but also marginally revised up the outlook for GDP for 2017. Keep in mind however inflation was only revised down for 2017. So, the Fed still expects inflation to rise again to 2% in 2018. This is something the Fed wasn’t able to maintain in a decade and puts into question its credibility on this kind of estimate.

The dot plot, which currently projects another hike in 2017 and 3 more in 2018, has also been systematically above the actual rate for years, as clearly indicated in the following table.

fomc and yield

Source: FOMC, Bloomberg

The market perceived the FOMC’s decision, statement and economic outlook as hawkish, but we need to remember that the Fed is trying to normalize and as such it doesn’t suit its interest to alarm the markets and shift course. Despite their recent comments if inflation doesn’t start to pick up — and soon—the Fed will have no choice but to halt its normalization process.

One reason for the Fed rushing into raising rates despite the weak economic data could also be the uncertainty around who will be the next chair of the FOMC. Yellen ends her first term in February 2018 and she may want to start normalization the balance sheet before then.

Even without this reason, which is only based on circumstances at best, the Fed wanted to raise rates in order to reduce some accommodation because it fears of overheating the economy – although, again, there really isn’t much evidence for over heat except for perhaps the low unemployment rate. This low rate, however, could also suggest a much flatter Phillips curve than the one prevailed in back in 80s and 90s.

Besides raising rates, the Fed also laid out a plan to reduce its balance sheet in a pace that will start at $10 billion a month and continue slowly until it reaches a pace of $50 billion. This means once the Fed starts off this process it will end up reducing $340 billion within a year or roughly 7.5% of its current balance sheet. This should help bring up long term yields but so far, the Fed’s efforts didn’t seem to work.

Bottom line

The Fed is still on course to normalize rates and its balance sheet. The data didn’t support a rate hike this time and as long as the data remain weak, the market will become more doubtful of the Fed’s guidance. If we were to see another a couple of months of weak economic data – including no reversal in the direction of inflation – the Fed will eventually have to acknowledge this and pause its normalization efforts.


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