Expected Fed hike in June may coincide with ugly reality: falling prices

February 13, 2015

FIf inflation expectations remain a prerequisite for higher interest rates, a widely forecast mid-year rate hike from the U.S. Federal Reserve is still not cast in stone.

The timing for the first interest rate hike in years for the world’s largest economy from 0-0.25 percent has been a matter of speculation for much of the past year and has set the course for currencies, bond yields and stock markets globally.

Even if symbolic, economists and Wall Street dealers predict the first hike will come in June — mainly because Fed policymakers seem to have done just about everything they can short of promising to raise rates then.

But that lands in precisely the same three-month period when economists, according to the latest monthly Reuters poll, expect inflation to dip below zero – meaning prices will likely be falling compared with a year ago.

This is a sharp downgrade from an expected 0.4 percent rise predicted just last month.

It also would mark the lowest point for U.S. inflation since October 2009 when policymakers the world over were terrified about prospects for a deflationary recession from which the U.S. economy is only now beginning to bounce back strongly.

A steep drop in global crude oil prices, from around $112 a barrel in July to just $60 a barrel now, coupled with slowing global demand, led by China, has triggered disinflation around the world.

This has prompted economists in Reuters polls to slash inflation forecasts across many important economies.

While central bankers are talking about “looking through” the oil price and what it has done to inflation, the moment when it dives to a low seems a tough sell to the general public for the timing of the first rate hike in over eight years.

Last July, when oil prices began falling in earnest, economists polled by Reuters predicted U.S. inflation would average 2.2 percent in the second quarter and through 2015.

But as the price of oil continued falling, those forecasts have been steadily sliced to -0.1 percent for a measly 0.4 percent average for 2015 in the latest poll.

Reuters Poll U.S. inflation consensus
for Q2 2015 (%)
Consensus for first hike in Fed funds rate
July 2014 2.2 Q2 2015
August 2.1 Q2 2015
September 2.0 Q2 2015
October 1.8 Q2 2015
November 1.4 Q2 2015
December 1.1 Q2 2015
January 2015 0.4 Q2 2015
February -0.1 Q2 2015

 

The lowest forecast for Q2, when the Fed is expected to embark on its long-awaited tightening campaign, is -1.3 percent. Inflation is expected to average less than 1 percent through most of 2015. Only one of the 60 forecasters expects it will go back to the Fed’s target level of 2 percent by the end of this year.

Kevin Logan, Chief U.S. economist at HSBC, who forecasts -0.4 percent in Q2, says:

The combination of faster prospective growth and lower inflation creates a quandary for the Federal Reserve. Plans for a rate hike at mid-year may have to be delayed until the policymakers are certain that inflation has stopped falling.

A move to a less accommodative monetary policy while inflation is moving further away from the FOMC’s 2.0% target could run the risk of pushing down the public’s expectations of future inflation, making it even more difficult to reach the target.

Indeed, falling oil prices and inflation rates have been accompanied by a raft of rate cuts and stimulus measures by global central banks elsewhere — including the Bank of Canada.

The latest surprise came from the Riksbank of Sweden, which cut its policy rate below zero this week and launched bond purchases, reversing a misguided move in mid-2011 to tighten policy in response to a perceived inflation threat.

The Fed is completely on its own in sticking to a long-held rough timetable for hiking rates.

Not long ago, the Bank of England was expected to raise rates around the same time, and for a brief while it was thought they might move before the Fed. Now, BoE Governor Mark Carney clearly has backed off the idea.

Inflation is expected to fall to just 0.6 percent in Britain this year and likely will turn negative some time soon.

Carney even raised the possibility of a rate cut at a press conference on Thursday. That has interest rate futures markets comfortably betting that Bank Rate, which also has been holding at a record low for years, won’t go up at all in 2015.

The problem for Janet Yellen’s Fed is that bond markets are fighting her. They don’t believe rates will go up in June, leaving the biggest gap between Fed rhetoric and market pricing in recent memory.

These latest inflation forecasts from the Reuters poll certainly aren’t going to change that.

Most of the discussion around a Q2 Fed rate hike has focussed on the recent acceleration in hiring and the view it would be prudent for the Fed to embrace an obvious early opportunity to “normalise” policy.

And it is true that central banks do not target the current inflation rate. They look several years out with the general view that it’s best to strike early instead of being behind the curve.

But given the powerful disinflationary forces the rest of the world is facing, the latest forecast data make it look tough for the Fed to justify a hike this year — especially starting in the quarter when inflation dips below zero.

Q2 US inflation

 

 (With inputs from Deepti Govind and Swati Chaturvedi)

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