If you’re confused about the state of the US economy and what it means for monetary policy, you’re not alone. Speeches by Federal Reserve bank presidents on Monday outlined starkly different tones on the inflation outlook, which suggests that the case for more interest-rate hikes in the near term remains muddled.
New York Fed President William Dudley offered a hawkish view, explaining that he sees inflation firming up and US economic growth holding steady at a moderate pace. “With a firmer import price trend and the fading of effects from a number of temporary, idiosyncratic factors, I expect inflation will rise and stabilize around the [Fed‘s] 2 percent objective over the medium term,” he said. “In response, the Federal Reserve will likely continue to remove monetary policy accommodation gradually.”
It’s fair to count Chicago Federal Reserve Bank President Charles Evans as a skeptic, telling reporters yesterday that forging ahead with rate hikes at this stage would be a “misstep.” A voting member of policy decisions this year, he explained that “we need to see clear signs of building wage and price pressures before taking the next step in removing accommodation.”
Evans added that he remains “nervous” about inflation’s outlook, advising that pricing pressures may be low due to structural rather than cyclical factors. “It’s not obvious to me that this is such a transitory event that [inflation’s] going to pop back up,” he said. While he doesn’t discount the possibility of a rate hike in the near future, inflation’s trend may remain clouded for some time, which suggests that debate about policy will roll on.
Last week’s August update of the consumer price index (CPI) supports Evan’s cautious outlook. For the fourth month in a row, headline CPI inflation was below the 2% target. Core inflation – considered a more reliable measure of the trend – held below 2% for a fifth month.
A second Fed bank president on Monday also made the case for going slow on rate hikes. “The Fed should be under no pressure to raise rates,” said Neel Kashkari, the head of the Minneapolis Fed. “We have time to let inflation climb back to target.”
Will this Friday’s update on personal income and spending for August, including the personal consumption expenditures (PCE) measure of inflation, give the hawks fresh support? Unlikely, according to Econoday.com’s consensus forecast. Economists are looking for core PCE, which the Fed watches closely for gauging inflation, to hold steady at a 1.4% annual pace – the sixth straight month of below-target inflation.
Low inflation is one reason why the Fed funds futures are pricing in a high probability – 98% at the moment – that the central bank will leave rates unchanged at the next policy meeting scheduled for November. Note, however, that a rate hike is expected at the December meeting: futures estimate the probability at 76%, based on CME data in early trading for Sep. 26.
Looking at the prospects for third-quarter GDP still suggests that moderate growth will prevail, albeit at a pace that’s well below Q3’s healthy 3.0% increase. Wall Street economists are looking for a 2.4% rise, according to CNBC’s Sep. 20 survey. That’s firm enough to keep the economy on an expansionary path, but it’s probably too soft to give the hawks a strong argument for hiking rates.
The futures market, however, begs to differ, in line with the latest comments by the New York Fed’s Dudley. Perhaps the deciding factor that breaks the debate, one way or the other, is next week’s employment report for September.
Meantime, the dispute about inflation’s trend and the implications for policy remain in play. As long as Fed officials have trouble speaking with one voice on the topic, the case is weak for arguing that another rate hike is imminent.
“The Fed’s rate projections are held together by the view that weak inflation is only transitory,” notes Tim Duy, an economist at the University of Oregon and a veteran analyst of the central bank’s monetary decisions. “But if this bet is wrong, the Fed risks a policy mistake that threatens the expansion and further entrenches inflation expectations below target.”