Near-Term Fed Clarity, but Future Is Cloudy

The market odds of a June 14 Fed rate hike have risen in recent weeks. Another 25-basis-point increase in short-term interest rates is seen as a near lock. However, the policy outlook beyond that has grown cloudy. Fed officials will revise their projections or growth, unemployment, and inflation this week. However, uncertainty around those forecasts should remain large. The dots in the revised dot plot may not shift much from where they were in March, reflecting continued expectations of a gradual pace of rate increases over the next couple of years. In contrast, financial markets see a less aggressive Fed, one closer to the end of the tightening cycle.

Recall that Federal Reserve policymakers had expected to be more aggressive in raising rates in 2015 and 2016, but hiked just once in each of those years (both at the mid-December meeting). According to Chair Yellen, that subdued pace reflected the impact of some global developments and a reassessment of the long-run normal level of the unemployment rate. With the Fed closer to its goals, the pace of rate increases was expected to pick up this year. The March rate increase and the anticipated June hike reflect that view.

Inflation appeared to pick up in the early part of this year, but the numbers are often a bit suspect in January and February. CPI figures for March and April reflect an odd mix. Ex-food & energy, we’ve seen a continued trend of mild deflation (a negative inflation rate) in consumer goods (about 19% of the overall CPI). Inflation in consumer services had been higher last year, reflecting rising rents and healthcare costs. The price index for non-energy services, which account for 60% of the overall CPI, moderated in March and April, reflecting a sharp drop in the price index for wireless telecom services (which is seen as a one-off). In other words, there’s general no inflation in “stuff” and higher inflation in services.