Beckner: With Inflation at 2%, FOMC Sets Stage for Higher Rates

Written exclusively for InTouch Capital Markets

2nd May 2018

The Federal Reserve could have given a blunter signal that it will raise interest rates next month, but its rate-setting Federal Open Market Committee clearly, if subtly, opened the door to a June rate hike as it concluded two days of meetings Wednesday.

With inflation finally on target, the FOMC made significant changes to its language on inflation in its policy statement. Instead of saying overall and core inflation “have continued to run below 2%,” as on March 21, the FOMC now says “on a 12-month basis, both overall inflation and inflation for items other than food and energy have moved close to 2%.”

The FOMC also altered the second, dual mandate paragraph. In March, it said, “inflation on a 12-month  basis is expected to move up in coming months and to stabilize around the Committee’s 2% objective over the medium term.” Now, it says, “Inflation on a 12-month basis is expected to run near the Committee’s symmetric 2% objective over the medium term.”

What’s more, a key phrase is conspicuously absent from the latest statement. In March, the FOMC said, “near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.” In the new statement, that second clause is gone. It simply declares, “Risks to the economic outlook appear roughly balanced.”

Meanwhile, the FOMC continued to point to strengthening labor markets and “moderate” economic growth. Whereas in March, it said household spending and business investment had “moderated,” the FOMC now notes business investment is growing “strongly.”

As in March, the FOMC “expects that economic conditions will evolve in a manner that will warrant further gradual increases in the federal funds rate.” But now, further rate hikes are more palpable. How soon and how many we get has yet to be determined.

The FOMC statement comes on the heels of the Commerce Department’s report that the price index for personal consumption expenditures (PCE) at last reached 2%. Although the Fed’s preferred inflation gauge was virtually flat in March, it rose 2.0% compared to a year ago. The core PCE rose 0.2% in March and 1.9% year-over-year. Achievement of 2% inflation came sooner than many expected. Fed policymakers had been confidently predicting inflation would rise to 2% “in coming months.” But in the March Summary of Economic Projections, FOMC participants didn’t forecast it getting there until next year.

As in March, the FOMC says market-based measures of inflation compensation “remain low.” In fact, although Fed officials continue to talk about inflation expectations being “low” and “well-anchored,” the closely watched five-year/five year forward inflation expectation rate, which measures average expected inflation over the five-year period that begins five years from now, has been climbing. As calculated by the St. Louis Fed, the “break-even” spread between regular and inflation adjusted Treasury securities (TIPS) has risen from 141 basis points in June 2016, to 199 basis points a year ago, to 210 basis points at the start of 2018 to 224 basis points as of April 30 — down from 235 basis points on Feb. 2.