Fed: Keeping the Faith

Published on July 14, 2017
Federal Reserve officials will have been hard pressed to find something positive in this morning’s CPI breakdown. The 1.7% annualized core CPI marks the fourth month in a row of those stubbornly transitory downward pressures on prices, and our sense is that the Fed forecasters don’t really expect the upcoming core PCE print on August 1 to show any upward movement from 1.4%.
*** That said, the weak inflation numbers in themselves will not really alter the current policy debate within the Federal Open Market Committee. As we noted previously (see SGH 7/5/17, “Fed: Return of the Inflation Question”), the policy decision on the implications of this renewed persistence in low inflation won’t really come to a head until nearer year-end, probably at the FOMC meeting that starts on the last day of October, or Halloween appropriately enough. ***
Until then, the skeptics in the Fed and markets alike will have to just keep the faith.
An Eye on Inflation Expectations
Even the more hawkish-leaning Committee members, including Chair Janet Yellen, don’t really expect much upward movement through most of this year; that eventual rise in inflation to mandate-consistent levels, when a tight labor market will be finally driving up underlying price pressures and vanquishing these multiple transitory downward pressures, is more of a 2018 story.
It means that through most of this year, the behavior across the measures and surveys of inflation expectations will bear a particular scrutiny. As we previously noted, it is not so much the low inflation data per se that is driving the caution about future rate hikes among a growing minority of FOMC members, but there is shared concern across the Committee that further rate hikes amid low or falling inflation expectations would risk entrenching the persistence of low inflation and put the inflation mandate ever further out of reach.
So on that note, this morning’s University of Michigan surveys, which most Fed officials seem to hold a certain fancy for, showed both the one year and five to ten year consumer expected changes in prices up by a tenth of a point. Grace comes in small things.

Assuming those inflation expectations look to be still mostly anchored, then, and the data going into the fourth quarter stays on track with the forecast, the base case policy path remains a start to the balance sheet normalization at the September meeting, with a resumption of the rates normalization policy in a third rate hike this year at the December meeting.
And as long as the data runs in line with the forecast, the policy rate will be pushed to hailing distance of the assumed nominal neutral rate of around 2% by this time next year.
And a September Balance Sheet Bridge
One bright spot in the coming months is that the low inflation prints will not seriously intrude into the FOMC’s plans for the portfolio normalization. If anything, it may even help through its more neutral effects on the dollar, which could help underpin higher inflation next year, and perhaps help to steepen the yield curve.
Indeed, that is one reason the timing in a September announcement to start the reduction in the balance sheet provides something of a bridge between the current low inflation to the next rate decision in December.
It allows them to press ahead with the policy normalization strategy in steadily removing monetary accommodation, albeit with the balance sheet rather than rates, and in doing so, providing some running room to gauge how the data plays out on the assumed Phillips Curve trade-off between the labor market and inflation.
As an aside, there is no chance the FOMC will use their July meeting to start the portfolio normalization. While they are cautiously optimistic the balance sheet shrinkage will be so gradual and passive it will limit any market dislocations, just to make sure the Fed will be preceding the formal announcement of its balance sheet start with a long runway of communications to ensure absolutely no one on the Planet Earth can be surprised. 
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