Opinion
Adam Chester 28 Jun 2017 12:23pm

Will the Federal Reserve eat humble pie?

Amid signs of more mixed growth and a weakening of core inflation, the markets clearly think the Fed was wrong to raise interest rates. Adam Chester examines whether the gamble will pay off

/-/media/economia/images/article-images/federal-reserve-2-630-min.ashx
Caption: While the Bank of England mulled over the case for policy tightening this month, the US Federal Reserve duly delivered.

While the Bank of England mulled over the case for policy tightening this month, the US Federal Reserve duly delivered.

Not only did it raise interest rates by a quarter point - to a range of 1.00-1.25% - it also stuck to its previous "dot plot" forecast to raise interest rates further, to 2.00-2.25% by the end of 2018. It also pre-announced plans to start unwinding its balance sheet.

On current plans, it anticipates deflating its asset holdings by $10bn (£7.8bn) a month, potentially starting as early as September, rising in small increments every three months to $50bn.

Chair Janet Yellen played down the recent softness of inflation, which she attributed to temporary factors, and instead reiterated the expectation that the tightening labour market will eventually lift domestic price pressures.

Improving employment and inflation

The unemployment rate fell to a new cyclical low of 4.3% in May, while wage growth has remained relatively subdued at 2.5% year-on-year. Non-farm payrolls, which includes all jobs excepting farm work, general government employees, private household employees and non-profit organisation employees, increased by 138,000 rather than the anticipated 185,000.

Broader inflationary pressures across the US appear to have abated in recent months, with the annual consumer price index (CPI) falling to 1.9% year-on-year in May, compared with 2.8% only three months earlier.

Core CPI inflation, which excludes food and energy, has also fallen back in recent months and currently stands at a two-year low of 1.7% year-on-year. Despite this, US financial markets continue to largely ignore the Fed’s guidance.

Emerging differences

US government bond yields actually fell and we now think that there is a less than 50% probability of a rise before the end of the year. Meanwhile, markets are only fully priced to one more quarter point rise by the end of next year.

Amid recent signs of more mixed growth and a weakening of core inflation, the markets clearly think the Fed has got it wrong. This misalignment can only last so long. Either the Fed will have to eat humble pie, or the US and by extension global bond markets could be in for a much more testing second half.

The markets will be closely scrutinising comments from policy makers for an indication of how strongly they hold their convictions.

New York Fed president William Dudley backed Yellen when he agreed that the tight labour market will cause inflation to rebound, after its proved unexpectedly weak during recent months, while the recent mixed set of economic data and lower Trump stimulus expectations have weighed on longer-term market interest rates.

We maintain our expectation of one further US Fed rate rise this year, in September, although the risk this may be delayed until December has risen. Policymakers will be watching for confirmation that the economy evolves as expected before they make the next move.

Adam Chester, head of economics, commercial banking, Lloyds Bank

Topics