Read our lips – no more Fed hikes
By Lars Christensen, Founder & CEO, Markets & Money Advisory
Not long ago everybody was talking about Trumpflation and the big reflation trade. The Federal Reserve jumped on the bandwagon and not only hiked its key policy rate, but also started talking about balance sheet 'normalization'.
But recent economic data in the US certainly does not support the reflation story. Hence, today we got data for US Personal Consumption Expenditure (PCE) and for the PCE deflator, which of course is the inflation that the Federal Reserve targets.
PCE growth stalled in March and the PCE deflator showed that both headline and core inflation slowed in March.
We see two messages from this.
First of all, the slowdown in PCE growth is a clear indication of slowing nominal demand – essentially tighter monetary conditions – which is an indication of lower medium-term inflationary pressures.
Secondly, the drop in both headline and core PCE inflation is a clear indication that the rise in inflation in recent months has been of a temporary nature.
Core inflation to drop further and remain well below 2%
Taken together, these figures tell us that the short-term lift in US inflation has come to an end and that core inflation is likely to drop further in the coming months, remaining below present levels until at least September.
Hence, the Fed will probably be dealing with lower inflation at both the June and September FOMC meetings. The monetary policy conclusion from this should be obvious – there is no need for more rate hikes.
Furthermore, with nominal demand remaining well below what we consider to be consistent with hitting the Fed's 2% target for PCE core inflation, it is also likely that the Fed will continue to undershoot its target in the coming 2-3 years.
In the April edition of our Global Monetary Conditions Monitor published on Friday, we showed that US monetary conditions remain too tight. Our country indicator remained below zero, suggesting the Fed is more likely to undershoot than overshoot its inflation target in the medium term.
The graph below shows our indicator for US monetary conditions.
Based on recent inflation trends and our country indicator, we can make a US inflation forecast, as seen in the graph below.
As explained above, we expect inflation to slow further in the coming months. Price growth will rebound in 2018, but it will still remain well below Fed’s 2% inflation target.
We said it before - no more hikes from the Fed in 2017
Presently, the markets are pricing in a bit more than one 25bp rate hike from the Fed over coming 12 months. However, if policymakers want to stop undershooting their inflation target over the medium term, they clearly need to ease monetary conditions relative to present market pricing.
The Fed should not hike rates any further in 2017 - or alternatively, send a clear signal that it will postpone any balance sheet ‘normalization’ until inflation expectations are in line with its inflation target.
If the Fed decided to rush ahead with monetary tightening anyway, we would expect inflation expectations to keep falling and the stock market to repeat the kind of sell-off we saw in early 2016.
Wednesday's policy announcement will be the FOMC’s first opportunity to get back on track, but it is hard to be optimistic that the Fed has understood the message. We certainly hope so.
If you are interested in our take not only on the Federal Reserve, but also on 24 other central banks around the world, then you should subscribe to our Global Monetary Conditions Monitor. For more information, contact us by writing an e-mail to email@example.com, or look here.