The Consumer Price Index (CPI) rose a moderate 0.2% in May compared to April, but jumped 2.8% compared to this time last year. Sharp increases in the price of energy contributed to those gains. Prices for the hospital and prescription drug components of the index also accelerated. Costs of shelter accelerated; that is one of many factors pushing up core inflation. Core inflation (excluding food and energy) rose 2.2% from a year ago.
Both core and headline CPI measures affirm our view that the economy has finally reached a turning point on inflation. This is welcome news to the Federal Reserve, which has waited much of the expansion for inflation to firm.
The Federal Reserve is meeting now, June 12-13, to vote on interest rates. The June meeting will be followed by a press conference when Fed Chairman Jay Powell will explain the Federal Open Market Committee (FOMC)’s decision and update the economic outlook. We expect to see the following developments:
The FOMC - the policy setting arm of the Fed - will vote unanimously to raise the fed funds target one quarter point higher to a range between 1.75% to 2.00%.
The forecast for growth in 2018 will likely be revised up, which could expand the current, slim consensus to a total of four rate increases this year, up from three.
Prospects for inflation have also risen so Chairman Powell will be asked to clarify how much and for how long the FOMC plans to allow inflation to overshoot its target. It is not clear that the Fed has reached an internal consensus on how to convey its inflation target. That is on the Fed’s to-do list this summer. (See note below.)
Chairman Powell will have to address escalating trade tensions and the Fed’s internal discussions about the impact on the economy of tariffs, both enacted and threatened. He will be in an awkward position with the administration on this issue as the escalation ups inflation without offsetting wage hikes and could precipitate a recession.
Chairman Powell will be pressed to comment on the risks of contagion from Italy and emerging markets and what that could mean for policy decisions. Powell likes to color inside the lines, which means he will argue that the Fed’s focus is alway on the U.S. economy first. That is true until what happens abroad washes up on our shores; given the connectivity in financial markets, it will.
For now, the Fed will hold to its schedule of reducing the bond holdings on its balance sheet, which will allow those assets to mature at an accelerated pace over the course of the year. This is theoretically removing a ceiling on long-term rates but could be overshadowed by immediate concerns about emerging markets, trade tensions and a flight to safety.
We would like to see Chairman Powell move to holding a press conference after every meeting. There is widespread support for this within the Fed. It would give the FOMC more flexibility in shaping market expectations about rate hikes by making every meeting “live," or has the potential for a change to be announced. The problem is timing. Powell will likely want to wait until we have clarity on trade policy if that is possible.
The Federal Reserve should have reached a point in this cycle when it can declare victory. That is not possible due to policy inconsistencies and uncertainty.
Note: The Fed has not clarified what symmetry in the inflation target means. Does it mean that 2.3% inflation will be tolerated for six months or one year? Would it be better to shift to a level target that just allows inflation to catch up to a pre-set goal? Or, is the target contingent upon wages
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