Soft inflation data throw Fed tightening into doubt

Added 14th July 2017

Friday’s US inflation report suggests the recent streak of soft CPI inflation may be more persistent than the Fed initially believed, decreasing the likelihood of further rate rises.

Soft inflation data throw Fed tightening into doubt

At 1.6% year-on-year and even 0% month-on-month, inflation is now only marginally higher in the US than it is in the eurozone, but monetary policy in the two blocs could hardly be more different. While the ECB is still busy buying bonds, the Fed has embarked on a series of rate hikes.

With inflation data so sluggish, will the Fed be forced to halt its tightening?

“The US Fed remains the test case for whether central banks can ever ‘normalise’ rates. We expect it to try, but fail - hiking the funds target just once more, probably in December,” said Neil Williams, chief economist at Hermes Investment Management.

“With the lagged effects of previous hikes yet to come, as it takes an average 18 months before rate hikes affect consumer spending in full (…) this would mean a peak of 1½% - way lower the 3% etched into the Fed’s ‘dot plot’ and the historic average of about 5%.”

Lower long-term inflation expectations would mean not only that the Fed would likely lower the pace of rate hikes. It should also lead to a flatter yield curve.

“The US Fed remains the test case for whether central banks can ever ‘normalise’ rates. We expect it to try, but fail" - Neil Williams

Recently, however, the opposite has happened, with US 10-year yields rising over the past few weeks while 2-year yields have been largely unchanged.

“Low-flation causes investors and central bankers to wonder whether and how much lower they should revise down their expectations with regards to neutral long-term interest rates. In this context, a bear steepening seems a counter-intuitive reaction,” said Mark Dowding, co-head of investment grade debt at BlueBay Asset Management.

“In the light of Chair Yellen’s comments over inflation, the market is no longer convinced that the Fed will tighten monetary policy again this year, overnight interest swap rates now implying a less than 50% chance of a December hike,” said David Page, an economist at AXA IM.

Transitory or not?

But is inflation really edging lower, or could it still be transitory? The Institute of International Finance looked at the issue, and concluded that “some of the inflation deacceleration we have seen recently is due to temporary factors [falls in communication costs, pharmaceutical drugs and energy prices], and as such will drop out of the inflation rate in due course.”

“As such, we remain confident that underlying inflation remains in line with where our model would suggest, and we expect the Fed to continue on their path to normalization,” the institute added.

That assessment is shared by AXA IM’s Page: “We see ‘core’ inflation likely to have found a bottom at these rates and expect a modest upward drift over the coming quarters. We continue to forecast a final 0.25% increase in the Fed Funds Rate in December,” he concluded.  

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Tjibbe Hoekstra

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Tjibbe joined Expert Investor as a senior reporter in March 2014. Before moving to London he worked as a financial news reporter for various news outlets in Amsterdam, including Reuters and ANP, the main news agency in the Netherlands. He also worked for Fondsnieuws, a website and magazine for finance professionals in the Netherlands. Tjibbe holds a MSc in Public Administration and a post-graduate diploma in Journalism.

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