Low Inflation Will Likely Convince The Fed To Cut Rates

The Federal Reserve is widely expected to trim interest rates tomorrow, and the prospect of low and possibly lower inflation in the months ahead is a key factor.

The Treasury market’s implied inflation forecast is hinting at the possibility that pricing pressure may be set for a new downturn. The spread on the 5-year nominal and inflation-indexed Notes, for instance, has been inching lower in recent days, suggesting that this barometer of market-based expectations is once again poised to slide.

After stabilizing at around 1.6% earlier this month, the implied 5-year inflation outlook eased in the last two trading sessions to settle at 1.57% on Monday (July 29). It’s unclear if this is noise or the start of a new downturn, but in the wake of softer economic growth in the second quarter the crowd may be inclined to price in a new round of diminished inflation forecasts.

Official inflation estimates are higher, but it’s clear that the hard numbers reflect subdued inflationary pressures lately. The annual core rate of consumer inflation, for instance, has been holding steady at or near the 2% mark, which is the Fed’s inflation target. The upcoming July report for the Consumer Price Index is on track to reaffirm that core CPI will remain at the 2% level, give or take, and drift lower in the months ahead, based on the average point forecast via The Capital Spectator’s combination-forecasting model.

Adding to the downside bias for inflation are studies showing that “a large segment of the economy,  from health care to durable goods, appears insensitive to rising or falling demand,” The Wall Street Journal reports. “Many of the prices consumers pay don’t respond to the strength or weakness of the economy.”

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Whatever the reason, a number of analysts say that subdued inflation, which may drift even lower, is at the forefront of the Federal Reserve’s policy focus these days.  

“We have a very tight labor market. We have ongoing wage gains. We have strong consumer optimism. That combination should lead to solid consumption, but because of the lack of inflationary pressure, the Fed has space to ease policy to extend the cycle,” says Jon Hill, a BMO rate strategist.

Veteran Fed watcher Tim Duy, an economics professor at the University of Oregon, agrees, noting that “subdued low inflation remains important for sustaining the Fed’s dovish feeling.” He predicts that “the Fed will cut rates 25 basis points this week with [Fed Chairman] Powell retaining the option for further cuts depending on data/risks.”

Fed funds futures are on board with that forecast. CME data this morning reflects a near certainty of a cut, with a 74% probability that the central bank will announce a ¼-point reduction to a 2.0%-to-2.25% target range in tomorrow’s FOMC announcement.

The stars may be aligned for the first round of monetary easing in over a decade, but the Fed’s board is increasingly conflicted on the subject of rate cuts.

“I would guess some members of the FOMC feel like they’ve been painted into a corner here because of the very aggressive pricing in the market,” advises Ethan Harris, head of global economics research at Bank of America Merrill Lynch. “You’ve already had [Boston Fed President Eric] Rosengren come out and say he doesn’t think a rate hike is justified. Most members of the committee are willing to consider rate cuts but the impression is the big three seem to have put a bulls eye on the July meeting, and I’m not sure that’s shared by the whole committee.”

There’s a growing concern that rate cuts, after a decade of extraordinary efforts at monetary stimulus, have lost some of their power to juice economic activity. “The Fed feels the need to come in and save the day like Superman, but all the Fed is going to do is encourage more corporate debt,” observes Peter Boockvar, chief investment officer at Bleakley Advisory Group. “It’s not going to help, and then the Fed will keep cutting.”

Tendayi Kapfidze, chief economist at Lending Tree, forecasts that “a Fed rate cut will have zero impact on the housing market. Mortgage rates are already at three-year lows.”

Perhaps, but with the crowd expecting fresh stimulus, the Fed risks a backlash if it stands pat, which would open the central bank to criticism that it’s lost control of its ability to manage policy expectations.

There’s also a political elephant in the room that’s complicating the Fed’s policy plans, courtesy of President Trump’s public demands for rate cuts.

“There is just no question that Powell has been ‘Trumped’ here,” says Ed Yardeni of Yardeni Research. “Just read Powell’s comments during his recent congressional testimony and trade comes up eight times in the context of weighing on the global economy. All Trump had to do was keep up geopolitical trade uncertainty for a while and he’d get the Fed to cut rates.”

The bottom line: the Fed finds itself in an comfortable uncomfortable spot: growing skepticism that monetary policy resonates with the real economy and rising political risk that threatens to undermine the central bank’s credibility. The first question: Can Fed Chairman Powell change the narrative in tomorrow’s press conference?

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By James Picerno

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  1. Pingback: Low Inflation Key Factor in Rate Cut - TradingGods.net

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