Concerns over North Korea notwithstanding, the other major stand-off in global markets at present is between fixed-income traders and the Federal Reserve. Their point of contention? The outlook for US inflation.
The outcome of this battle will set the course of interest rates and bond yields – and even the $US – over the remainder of the year.
Specifically, at issue is whether recent decline in US inflation – which has become a growing source of frustration for the Federal Reserve – will prove as “transitory” as Janet Yellen expects. If so, the Fed will remain on course to lift interest rates again in December, and will likely reiterate its intent to lift rates three more times in 2018.
For financial markets, that could come as somewhat as a shock. After all, the market now attaches less than a 50% probability to a further rate rise this year, and is even dubious the Fed will hike rates again in 2018. In fact, the market attached on a 2% probability that the current median “dot point” forecast among voting Fed members will be realised over the next year and a half.
By way of backdrop, note that US inflation has eased back in recent months after lifting tantalising close to the Fed’s 2% inflation target earlier this year. Just when the Fed though it had won the inflation battle, victory was snatched from its hand’s within a matter of months. Specifically, annual growth in the core private consumption deflator (PCE) had reached 1.9% in February this year, but has sunk back to 1.5% by June. As usual, trends in the headline PCE deflator were more pronounced, falling to 1.5% from a February peak of 2.2%.
Does this matter? Fed chair Janet Yellen is already on record noting that the outlook for inflation is now critical to the outlook for interest rates. In testimony in July, Yellen noted “with inflation continuing to run below the Committee’s 2 percent longer-run objective, the FOMC indicated in its June statement that it intends to carefully monitor actual and expected progress toward our symmetric inflation goal.”
“Carefully monitor” is code for reviewing its intention to lift rates unless inflation rises. That said, Yellen remained confidence that inflation would rise, noting that “a few unusual reductions in certain categories of prices” helpfully temporarily lower prices in recent months. The two culprits identified by the Fed are mobile phone charges and prescription drugs.
Drilling into the details, there’s been a large drop in mobile phone costs in recent months, due to intensified price discounting – prices are down 13% on year ago level thanks to a move to unlimited data plans by many phone retailers. Prescription drug prices also dropped back earlier this year, partly as a correction to strong gains in 2016.
On the Fed’s view, as price levels in these areas stabilise, inflation will tend to lift back to its truer underlying pace. That may mean monthly inflation gains lift in coming months, though annual rates will be held down for a while long – until the one-off drop in price levels drop out of annual calculation this time next year.
The market is not so sure. Indeed, even excluding these items, inflation nonetheless appears to have dropped in recent months. Other factors in play are slowing growth in housing costs, due to a softening in rental markets. Used car prices have also weakened due to a glut of stock on the market.
More broadly, it’s generally always possible to find one to two items that are experiencing unusual price weakness – just as there will be some displaying unusual price strength. What matters is the overall trend in prices, which is perhaps best captured by the “trimmed mean” estimate of PCE inflation in the chart above. On this score, annual inflation has dropped from 1.9% in February to 1.7% in June.
To my mind, the market likely senses the Fed is holding itself to an unrealistic target. Headline consumer prices have averaged less than 2% – 1.8% to be exact – since the broad stabilisation in inflation at lower levels in the late 1990s. Core PCE inflation has average only 1.7% an annual inflation on this basis has been below 2% for around 75% of the time.
Chances are that the next few month of inflation readings may be a little higher than the unusually weak readings of recent months – in which case the Fed will still hike rates in December and bond yields may correct higher. But while the Fed could win the battle in the short-term, it seems likely to lose the war – as I suspect inflation will prove frustratingly low next year. That’s what markets are counting on, which adds to the upside risk to equity prices once the Fed concedes and winds back its interest-rate tightening intentions.