Home Business Inflation Underestimation: It May Rise More Than Fed Expects – Capital Econ

Inflation Underestimation: It May Rise More Than Fed Expects – Capital Econ

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Inflation Underestimation? Inflation in the U.S. is rebounding, but the Federal Reserve’s dovish tone around the March meeting suggests that it could be underestimating how much it will rebound this year, suggest analysts at Capital Economics. But we’re getting mixed signals from policymakers as speakers from the Federal Open Market Committee sounded more hawkish after the March comments—even though the Fed’s interest rate projections were cut at this month’s meeting.

Inflation Underestimation – Skeptical about the Fed’s inflation projections

In a report dated March 28, Capital Economics analysts said they’re skeptical that the Fed has become more willing to allow inflation to run above its target. Rather, they believe most policy makers just “don’t appreciate how quickly inflation will rebound in the second half of this year.” They point to the U.S. dollar’s decline and the steady increase in commodity prices since the Fed’s meeting as evidence for their view that inflation will be bigger than previously expected.

Monday’s report on personal income and spending for February brought mixed data. Personal income and consumption beat estimates at an increase of 0.2%, and spending increased 0.1%, compared to the consensus of 0.1% for both. Core personal income climbed 0.1% month over month, missing the consensus of an 0.2% increase. Wages and income declined $9.4 billion in February, which means that the increase in income came from transfer receipts, income and rental income. The savings rate was 5.4%.

One problem in Monday’s report though was major negative revisions to January’s numbers. The January personal spending number was revised downward from the previously reported increase of 0.5% to an 0.1% increase, while spending was revised downward from 0.5% to flat.

Today we’re looking forward to the release of the Consumer Confidence report, and Capital Economics analysts believe it ticked higher, driven by gains in the stock market. The employment report is due on Friday, and they believe the U.S. added 180,000 jobs in March and a 0.4% month over month increase in average hourly earnings.

Inflation Underestimation – How many Fed rate hikes will we see this year?

There’s plenty of debate about whether we will see two or three Fed rate hikes this year, with some pricing in two and others three. Analysts at Capital Economics expect three hikes, each of 25 basis points, although the Fed’s median projection now suggests that policy makers will only hike rates twice. The firm said seven out of 17 officials still expect at least three rate hikes.

Its analysts add that they differ from most others because they expect interest rates to increase much faster next year than what the Fed’s projections currently suggest. They’re projecting a Fed funds rate of between 2.25% and 2.5%, while the Fed’s projection indicates a rate of 1.75% to 2%.

Core inflation on the rise

Capital Economics analysts note that core CPI inflation has been trending upward for quite some time as it hit its highest level in four years last month. They add that the core PCE inflation increase has come more recently, which they say is because a “one-off structural drop in medical care prices in late 2014/ early 2015 kept it artificially depressed last year.

“Fed Chair Janet Yellen expressed some scepticism in her post-FOMC press conference that the rise in core inflation was a genuine cyclical upturn,” the Capital Economics report rates. “That strikes us as a remarkably cavalier view to take when the economy is either at, or very close to, full employment and when the annual growth rate of unit labour costs has accelerated to 3%. In that environment, rising core inflation is exactly what we would expect to see.”

Inflation Underestimation – Fed to realize inflation projection error in 2H?

They go on to note that it looks like Yellen is focusing more on the core goods inflation rate but add that there are “suspicious looking increases in the prices of clothing and jewellery.” However, they also say that goods are only 20% of the core CPI and that services are uch more important.

Inflation Underestimation

They argue that the Fed might not realize its error in inflation projections until the second half of the year and that their concerns about the global economy might be shifted to the background.

“The markets are already waking up to the possibility of above-target inflation and it’s possible that this, rather than the actual inflation figures, is what will nudge the Fed into action,” they wrote.


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