Tug-of-War: Fed Signals vs. Market Pricing
As expected, the Fed raised the Fed Funds Rate by 25 bps at its June meeting. Committee projections suggest one more rate hike this year and a pace of roughly three hikes per year in 2018-19. The announcement was seen as “hawkish”, as the Fed also suggested a gradual balance sheet normalization program to begin sometime this year.
Markets price in a little more than one 0.25% hike per year in the near future, and a tug-of-war between the Fed’s signals and market pricing could be a source of volatility going forward.
However, the Fed is facing a conundrum at the moment with a tightening labor market, yet inflation data has recently been surprisingly low. In May, core inflation dropped to 1.7% from 1.9% in April – a two-year low.
Core Inflation (Excluding Food and Energy)
Sources: Thomson Reuters Datastream, New York Life Investments, May 2017. Past performance is no guarantee of future results. An investment cannot be made directly into an index.
Large price cuts for unlimited cell phone data plans have recently pushed down inflation. That’s an example of how technological changes and automation are causing structural downward pressure on costs. The good news is that these structural changes also enable the economy to operate at a higher activity level, without stoking inflationary pressures.
Despite recent weakness, it is too early to rule inflation completely out. With increasing signs of labor market tightness, a stabilizing U.S. dollar, and a pickup in global economic growth, core inflation is more likely to trend up than down over the next 6-12 months. On the growth front, consumer spending showed a solid trend for the March-May period, and indicators for manufacturing in June looked encouraging.
Overall, growth signals for the second quarter point to a decent rebound from a weak first quarter.
Indicators Point to Q2 Rebound
Sources: Thomson Reuters Datastream, New York Life Investments, May 2017. Past performance is no guarantee of future results.
Clearly, weakness in inflation does not necessarily equate to weakness in growth, and data actually point to tailwinds for corporate revenues in Q2. For investors who worry about the potential for an uptrend in inflation, commodity-sensitive assets can be a good way of diversifying a portfolio.
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The core CPI index excludes goods with high price volatility, such as food and energy. This measure of core inflation systematically excludes food and energy prices because, historically, they have been highly volatile and non-systemic.
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