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Investment

Low inflation crimps Fed's ability to hike interest rates this year

Flat consumer inflation and a surprise drop in June retail sales triggered new doubts that the Federal Reserve will be able to raise interest rates again this year.

“This is a game change for market expectations. Now it’s when does the Fed respond and what does transitory really mean,” said Ian Lyngen, head of U.S. rates strategy at BMO. Lyngen said fed funds futures were reflecting odds for another rate hike this year of just 46 percent, down from 52 percent before the data, according to Lyngen.

Fed Chair Janet Yellen raised the level of anxiety about inflation when she said told a congressional committee this week that the central bank was concerned about low inflation and would change its policy path if it persists. That was a slight departure from previous Fed comments that the softening inflation is “transitory,” and likely due to temporary events like a drop in wireless charges or lower drug prices.

In the bond market, yields fell with the 10-year Treasury briefly dropping through the key 2.30 percent level, raising the prospect of a swift move to 2.20 percent. The yield was at 2.31 percent in late-morning trading. The stock market took the reports in stride and was higher.

Some economists changed their views on the likelihood of a third rate hike for this year. Goldman Sachs economists said the probability of another rate increase went to 60 percent from 70 percent before the CPI report. JPMorgan said a December rate hike now depends on second-half inflation data.

Michael Gapen, chief U.S. economist at Barclays, said the soft data does not change his view that the Fed will start unwinding its balance sheet in September and raise interest rates in December. Citigroup economists also stuck with that view of a December rate hike.

“The [Federal Open Market] Committee is already saying we expect weakness in inflation due to base effects through Q1 of next year,” Gapen said. “Our baseline is they still do the balance sheet in September, and they hike rates in December. I don’t think inflation is likely to alter their plans until early next year. The risk is they alter their path for next year.”

The consumer price index, measuring what consumers pay for everything from apparel to used cars, was unchanged in June from the prior month. From a year earlier, the CPI was up 1.6 percent, the fourth month of surprising weakness. Excluding food and energy, the core prices rose 0.1 percent, compared with expectations for 0.2 percent.

“What I think is happening is that consumer goods are in deflation from things like a structural shift in the retail sector, where e-commerce threatens brick and mortar in a way the traditional retail sector is cutting prices as they try to hold onto market share. It’s a structural threat to their existing business, and they’re competing against it,” Gapen said. He added that overproduction by the auto sector also resulted in lower new and used car prices in the report.

Retail sales fell 0.2 percent in June, down for a second month. That was the first time they fell two months in a row since last summer. The weak retail sales raised concerns in markets about the strength of the economy, but Gapen said he views the report as volatile and leaves his tracking of GDP in the second quarter unchanged at 2.5 percent.

“It just means easier monetary policy and lower rates for longer — that’s the narrative that the equity market is following at the moment. I still think the Fed has a good chance of following through on tapering and I always thought a hike in the second half of the year was going to be a challenge, to put it mildly,” said Lyngen.

But in the bond market, there remains consternation over the Fed’s seeming about-face on inflation concerns, and also Yellen’s comment that the neutral rate will remain below historic levels, suggesting fewer rate hikes in the current policy path.

Global sovereign yields had been rising for the few weeks before Yellen’s testimony on the belief that central banks were beginning to step away from extraordinary easing, led by the Fed.

“This has been a bewildering week as far as the message from the Fed is concerned. I think these inflation numbers have rattled their case somewhat. Janet Yellen’s description of inflation changed from idiosyncratic to unusual. I think she had a handle on what this CPI number was going to be,” said Ward McCarthy, chief financial economist at Jefferies.

The Fed has a target of 2 percent inflation, and core CPI had been at that level throughout 2016. But the central bank’s preferred inflation measure, the PCE deflator, has lagged and was at 1.4 percent.

“I think this has caused some consternation not just with Janet Yellen but with other people at the Fed, as well. It does look like it’s going to slow down the normalization process,” McCarthy said.

John Briggs, head of strategy at NatWest Markets, said investors will now wait for next week’s European Central Bank meeting to see if there is action there.

“People have been whipsawed by central bankers in the last couple of weeks,” he said.

Briggs said he does expect inflation to turn higher later in the year. “Low inflation is the theme of the summer,” he said.

Source: Investment Cnbc
Low inflation crimps Fed's ability to hike interest rates this year

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