The Fed could be back in play in 2016

One or more rate hikes by the Federal Reserve in 2016 remains a real possibility. Why would the Fed consider such a policy action given the recent collapse in inflation expectations?

Over the past couple of months many analysts and the futures markets have assigned a rather high probability to the so-called "one and done" - no change in policy in 2016. Indeed, here is what we've heard recently from St. Louis Fed President James Bullard:

Reuters: - The Federal Reserve must act to stop inflation expectations from getting too low, St. Louis Fed President James Bullard said on Wednesday, reiterating his concerns about continuing to raise interest rates.

The U.S. central bank cannot let low inflation expectations "get out of hand," he told a dinner of bond traders here, adding he "can't stomach" currently low readings. "It's just that they've fallen so far that it's got to be a concern."

Source: @auaurelija

However a number of researches have suggested that with a relatively stable core inflation in the United States, oil prices would need to collapse to levels that are neither consistent with today's forward curve nor sustainable. Therefore, these studies argue, the current market-based inflation expectations are simply irrational.

1. Here is the latest analysis from Goldman Sachs.

Source: Goldman Sachs

2. Also, a study from the St. Louis Fed shows a similar result.

Source: St. Louis Fed

Moreover, US inflation measures are starting to stir - especially in the services sector. This is something the FOMC is not going to ignore. Below we have some of the recent reports.

1. The core PCE inflation, the Fed's primary inflation measure, exceeded consensus on Friday.

2. US CPI measures, both the headline and the core, also came in above expectations.

Source: Investing.com

3. As an example of where some of this inflation is coming from, shown below is the medical care CPI. It has been subdued last year but is now is waking up again.

Source: St. Louis Fed

Additionally, the cost of shelter in the US is now rising at over 3% per year, with the rate continuing to increase. Sadly, this is materially higher than the national wage growth rate, putting pressure on Americans with low-paying jobs.

Source: St. Louis Fed

4. We also see the so-called "sticky" CPI (the less volatile components of the CPI) reaching 2.5% - the highest since 2009.

Source: St. Louis Fed

Some analysts (RBS for example) have been suggesting that deflation is about to sweep the global economy, pulling in the US along the way. For now however there is simply no evidence of deflationary pressures in the world's largest economy.

Other indicators released last week could add to the ammunition of the more hawkish FOMC members.

1. US consumer spending was stronger than expected last month. Alas, some of this increase was driven by higher spending on healthcare, but it's an important data point nevertheless.

Source: St. Louis Fed

2. While this next item is more symbolic in nature, it's an important milestone nevertheless. US house prices (at least according to the government's index) are finally above the pre-recession peak.

Source: St. Louis Fed

The futures markets are starting to react to all these reports, with the Fed Funds futures falling on Friday (lower futures prices imply higher rates).

Source: barchart

In the coming months the Fed will be closely watching two key economic measures as the Committee contemplates further rate hikes.

1. Any indications of acceleration in wage growth will get the Fed going again. The high-frequency Gallup jobs indicator suggests that US labor markets remain stable, but material improvements in wage growth have been elusive.

Source: Gallup

2. The recent market turmoil has ignited concerns about tight credit conditions. The Fed's surveys suggest stricter underwriting standards in business lending while other indicators point to weakness in credit availability for middle-market and smaller businesses. And of course credit spreads have risen sharply, especially for the more leveraged firms. However the overall corporate loan growth remains close to 11% per year - for now.

Source: St. Louis Fed

Some suggest that raising rates in the current environment is nothing short of insanity. Given the monetary easing by the ECB, the BOJ, etc. (as rates move deeper into negative territory) or the dovish stance by the BOC, the BOE, and others, the US dollar is bound to resume its rally, causing further damage to the US economy. In fact the latest PMI measures, (from Markit as well as ISM) suggest that the US economic activity has already slowed sharply in the first quarter. Nevertheless, given the Fed's focus on some of the indicators discussed above, rate hikes in 2016 are now back on the table.

Source: Markit

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The possibility of a 2015 rate hike in the US should not be ignored

Futures-implied probability of a 2015 rate hike in the United States remains below 40%. Some market participants have all but dismissed this possibility as they look at weak global growth as well as soft inflation and inflation expectations in the US. Some have even suggested that the next policy move by the Fed should be a rate cut into negative territory.

Source: St. Louis Fed

However global growth and US inflation expectations may not necessarily the main focus at the Fed. For example, numerous economists continue viewing the energy market crash as having only a transient impact in inflation. The logic here is that if we freeze crude oil prices at current levels (below $45/bbl), by early 2016 the year-on-year change will be around zero.

And a number of energy analysts expect crude oil prices to begin gradually rising going forward. To many forecasters this would imply that crude oil price weakness will no longer have such a severe impact on the rate of inflation.

Of course some would say that low fuel prices have not yet fully made their way through the economy - suggesting that the disinflationary pressures will persist for some time. Similarly some argue that the full effects of the dollar rally in the first half of 2015 are yet to be fully felt.

Nevertheless many economists view the headline inflation approaching the core measures by early 2016, with the core CPI turning higher as well. Moreover, a slew of recent US economic reports suggests that while the US economy probably slowed in the second half due to dollar strength and weakness abroad, the effect may be transient.

The housing market for example continues to recover and consumer sentiment and spending does not seem to be impacted by the recent market volatility.

Source: St. Louis Fed

Source: Scotiabank

Source: @GallupNews

Source: Deutsche Bank, @MKTWeconomics

Even US manufacturing which has been under pressure recently is showing signs of stabilization. The latest Markit manufacturing PMI report surprised to the upside.

Source: Markit, Investing.com

But what about the relatively poor payrolls report for September, which clearly missed expectations? Some economists argue that this is as much about slower hiring as it is about tight labor markets. For example (as we saw in the latest Pulte Homes quarterly report), the homebuilding industry is struggling with acute labor shortages. Of course as the Wall Street Journal recently pointed out, the US housing correction has been so severe that a whole generation of construction workers has permanently exited the industry, creating shortages as the sector recovers. Nevertheless when the Fed hears about labor shortages in an industry such as housing, they take notice.

Source: WSJ

Signs of tighter labor markets have also appeared in the latest NFIB reports on small business. When speaking with small businesses it becomes clear that there is no shortage of applications for each opening they have. But they can't seem to find people with the right experience and/or skill set (skills gap).

Source: NFIB

Moreover, the broader unemployment measures continue to improve. Here is the so-called "U-6" for example, which according to some economists is about 1% away from "full employment" (see quote).

Source: St. Louis Fed

Whatever the case, many argue that this is a precursor to acceleration in US wage growth. We haven't seen a great deal of evidence of that so far, but many economists (including those at the Fed) are convinced that it's only a matter of time.

One of the concerns the FOMC had in September was the risk of a rapidly deteriorating economy abroad, particularly in China. It has since become clear that while China's economy continues to slow, the combination of aggressive fiscal and monetary stimulus there is likely to cushion the decline.

Source: Investing.com

Some may remember that in September of 2013 in the wake of the so-called "taper tantrum" the Fed decided to continue with QE. The central bank however started tapering three months later. The "playbook" this time around could be similar.

Are global markets prepared for a December liftoff? It seems that while credit markets remain cautious, there is much less uncertainty priced into US equity markets. A relatively strong employment report next week for example could reignite market volatility.

Source: BAML

Many argue that the US economy can withstand a rate hike at this point. Indeed it can. However, given that much of the world is currently in a monetary easing mode, such a move by the Fed would result in a further rally in the US dollar. We saw the Bank of Canada strike a dovish tone recently, the PBoC is in the middle of a major easing cycle, the BoJ is in a perpetual QE, and the ECB is fully expected to expand its stimulus.

A further dollar rally would exacerbate the rout in emerging markets, potentially forcing China to resume the RMB devaluation. Disinflationary pressures in the US could worsen and the manufacturing sector would take another hit. Nevertheless, it seems that many at the Fed are willing to overlook such an outcome and begin the first rate hike cycle in nearly a decade.



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Sentiment shift on US inflation expectations

We seem to be undergoing a market sentiment change as fresh signs appear that US inflation has bottomed.

Commodity markets are firmer, particularly industrial metals. We've seen nickel prices moving up sharply a couple of days back (see chart). Here is aluminum and copper.

Commodity indices are still near multi-year lows but seem to have found a bottom - for now. Here is the CRB BLS Spot Index.

Source: barchart

Moreover, the components of the US Employment Cost Index seem to indicate improved wage growth as well stronger increases in starting salaries.

Source: Deutsche Bank

As a result we continue to see breakeven inflation expectations moving higher. The Eurozone has also seen an improvement in breakeven rates.

Perhaps the most telling sign that inflation sentiment has shifted is the record jump in inflation funds inflows (ETFs and mutual funds).

Source: Deutsche Bank

The dollar of course continues to pose risks to this change in investor views. Should we for example see a 300K new payrolls print from the labor department this Friday, all bets are off. The Fed will be back in play, the dollar rally will resume, and inflation expectations will dive again. Such an outcome with the jobs report seems unlikely but a resumption of the dollar rally remains a risk.

Source: barchart

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The Fed's policy trajectory is tied to global recovery

The latest US payrolls report presents a challenge for the Fed. As discussed back in April (see post), US labor markets are continuing to heal, suggesting that the rate "normalization" should be a serious consideration for the central bank. However the recent deterioration in commodities, especially energy, is "importing" global disinflation to the US (see post). In particular, the Saudi commitment to retake lost market share has sent shock waves through the oil markets (see post).

GCC is a diversified commodity index (source: barchart)

As a result, longer-term market-implied inflation expectations have fallen substantially.

The latest declines in expectations came after the recent FOMC minutes already showed increasing concerns at the central bank:

FOMC: - “Many participants observed the committee should remain attentive to evidence of a possible downward shift in longer-term inflation expectations.”

At the same time payrolls in the US are growing at a rate approaching the pre-recession peak (though still materially below what we saw in the 90s).

In fact the divergence between payrolls growth and inflation expectations is currently unusually high. Payrolls are driven by stronger US domestic economy, while inflation expectations are impacted by external factors, which creates this disconnect.

Red dot represents the current situation

This mismatch is causing a dissonance for policymakers and market participants, adding to the disagreement on the timing of liftoff. Current market expectations for the first hike now point to Q3 of 2015.

Source: CME

However if inflation expectations persist at these levels or worsen, it will be nearly impossible for the Fed to move on rates - irrespective of how much labor markets improve. The bet represented in the chart above is that energy prices will stabilize and/or growth in wages improves substantially by next summer - pushing breakeven expectations higher. But such an outcome, driven to some extent by factors external to the US, is far from certain.

What makes the timing of liftoff particularly difficult to estimate is the value of the US dollar.

Source: barchart

With a number of major central banks either easing or expected to begin easing monetary policy (diverging from the Fed), the rise in the relative value of the dollar will continue. That will bring inflation expectations even lower by weakening US import prices and pressuring commodities. If the strong dollar can make goods and to some extent services from abroad cheaper, there is less incentive for US-based firms to raise wages. Tapping cheaper markets abroad becomes more profitable.

And as the expectations of liftoff draw closer, the dollar will strengthen further, making it more difficult for the Fed to pull the trigger (what some refer to as a "self-correcting" mechanism). It's hard to envision the Fed acting unilaterally in the sea of looser monetary policy worldwide. The policy trajectory of the US central bank is therefore tied to a large extent to the global recovery, which remains elusive for now.

The Fed officials are keenly aware of premature policy tightening by a number of central banks, who were forced to reverse their decisions later.

Source: @themoneygame (Business Insider), Deutsche Bank

What some of these central banks didn't count on was the global nature of disinflation, over which they had little or no control (see chart). In the Fed's case, such a reversal would severely undermine the FOMC's credibility, sending policymakers back to the drawing board.
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How well does the CPI measure individuals’ health care burden?

Guest post by Jonathan Bernstein

Medical costs rose at an official rate of 1.7% year on year this past September, but the average increase in medical expenses individuals actually paid could easily be far larger. Most importantly, the CPI, as a pure price index, may not reflect the increased cost of living for families who lose employer paid health care coverage. That’s an all too common predicament, given the substantial fraction of part-time jobs created during the current economic recovery.

Nor does the CPI make it easy to see how reduced healthcare benefits raise the cost of living for those who still enjoy employer sponsored plans. As Aflac reports, 56% of employers offering health plans hiked the employees’ share of premiums or copays in 2013, and 59% expected to do so in 2014. Furthermore, the Affordable Care Act (ACA, or Obamacare) encourages this sort of cost shifting from employer to employee through its 40% excise tax on “Cadillac” plans.

The BLS does not measure insurance costs directly when compiling CPI-MED, the CPI’s health care component (h/t Doug Short). Instead BLS assumes that insurance costs rise commensurately with the prices of medical goods and services, plus or minus a margin for profit and administrative costs. Since CPI-MED measures changes in medical prices faced by consumers, it calculates changes in net prices charged to consumers after insurers, if any, have paid their share. As individuals and families pay an increased percentage of their healthcare costs, the BLS will account for that by increasing the weight of CPI-MED within the overall CPI; currently CPI-MED accounts for 5.825% of the overall CPI. Increases in the share of medical expense paid by individuals (as opposed to their insurers), will not affect CPI levels.

Therefore, when the BLS re-benchmarks the CPI this coming February, we can probably expect CPI-MED to carry a larger weight than in the past. An increase in the weight would then tell us how much BLS estimates that the average consumer’s medical care expenses increased as a percent of his or her total expenses.

 To state the obvious: when a family loses their coverage, they could easily go from paying a $300 monthly share of an employer’s plan, to paying $1,200 or more monthly for a “gold” plan, depending on the parents’ ages and number of children. Alternatively, the family could buy a less expensive plan (or no plan at all), and consequently pay more of their medical bills out of pocket. Again, that shock, if experienced by enough people, will eventually show up in weight changes, but not in the CPI level.

Either way, for many if not most families, the resulting increase in health care costs works out to a double digit percentage increase in total monthly expenses. Increases in deductibles, premiums or copays for those who have employee coverage presumably hurt less, but would also boost the employee’s health care costs over and above this year’s 1.7% increase in CPI-MED. And let’s not talk about those who lose employer paid coverage but whose income is low enough to qualify for the Obamacare insurance premium subsidy. In that situation, one can’t afford the out of pocket cost for much non-emergency treatment, and emergency treatment cost may put one at risk for bankruptcy.

In sum: while the BLS tells us how fast medical costs are rising, the CPI’s headline numbers may not reflect how healthcare costs actually affect the cost of living. If you want to know why many people feel that they are falling behind despite benign official statistics, here’s one place to look.



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Dollar strength and inflation expectations

The ongoing strengthening of the US dollar could shift the FOMC further into dovish territory. While the labor situation continues to improve, the dollar's recent appreciation has contributed to declines in inflation expectations (based on TIPS breakevens) to multi-year lows.

Another way to think about this is that lower inflation expectations are equivalent to higher real interest rates - a form of "market-generated" tightening in monetary conditions. Central banks generally don't like to tighten policy when real rates rise sharply.

Part of the reason for weaker inflation expectations has been the decline in commodity prices - which to a large extent resulted from stronger US dollar (as well as slower growth expectations in China). A widely-tracked broad commodity indicator called the Continuous Commodity Index is now at the lowest level since 2010.

Source: barchart

Moreover, stronger dollar lowers prices of imported goods in the US. After a period of declines last year, growth in import prices finally turned positive this summer, providing support to the CPI. But as the dollar started appreciating, import prices began falling again, lowering US inflation and inflation expectations. We saw signs of that in August and are likely to see more declines in September (the report comes out in a couple of weeks).

Source: BLS

The Fed watches market-based inflation expectations quite closely and the dovish FOMC members may use this as an excuse to press for delays in rate normalization. If the US dollar appreciation continues at the current pace, the FOMC's dot-plot will begin to move lower.

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Deutsche Bank: Ignoring food price pressures could be a mistake

Economists and central bankers tend to be less focused on what consumers pay at the grocery store because food and energy prices have historically been more volatile - remember, it's just "noise". However what they can't ignore is how shoppers view inflation - i.e. inflation expectations. And food prices have a significant impact on households' views on future inflation.

Deutsche Bank: - ... food prices factor significantly into households’ perceptions of overall price pressures. This is illustrated in the following figure, which shows year-ahead inflation expectations from the University of Michigan Survey of Consumer Sentiment versus CPI food. In fact, it is worth noting that CPI food demonstrates a higher degree of correlation with one-year price expectations than either the headline or core metrics — and it similarly surpasses energy, core goods, core services and shelter. ...  while forecasters are focusing on service-sector inflation in general and shelter inflation more specifically, they should be careful to not ignore mounting food price pressures, because this category could provide important insight toward the evolution of inflation expectations. If food price inflation accelerates, as we project, the stability of inflation expectations could degrade - and this would be a vexing development for monetary policymakers.

Source: Deutsche Bank

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The US Phillips curve

We've received some questions about the so-called Phillips curve - the relationship between inflation and unemployment. While there are a number of ways to look at the Phillips curve, the services inflation measures are more suitable than the broader price indices in order to assess the relationship. That's because goods inflation in the US can be driven by global trends, while services tend to be more US-specific.

Furthermore, rather than using the headline unemployment rate ("U-3") it is more appropriate to use the "U-5" measure which captures a broader group of unemployed or marginally employed workers. U-5 is defined as "total unemployed, plus discouraged workers, plus all other persons marginally attached to the labor force, as a percent of the civilian labor force plus all persons marginally attached to the labor force".

10 years of data (orange = current levels)

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Is the recent US CPI increase just noise?

At her press conference yesterday, Janet Yellen dismissed the stronger than expected CPI report (see chart), as "noise". She was quite clear. Inflation remains below the Fed's target and is likely to stay there for some time.

Inflation sensitive assets such as gold however rallied in reaction to this dovish stance from the Fed.

Source: Investing.com

If the CPI report from the US Bureau of Labor Statistics was "noise", is there another measure that can give us a sense of where prices are headed? Today's Philly Fed report provided one such an indicator. The Manufacturing Prices Paid Index clearly showed firmer upstream prices.

And market-based inflation expectations, while still relatively low, have definitely moved up recently.

TIPS-based inflation expectations (source: Ycharts)

Certainly the Fed wants to see this trend sustained for some time. After all, inflation remains at dangerously low levels in the euro area and we could see price increases stalling in Japan later this year (see discussion). But we have clear indications that at least for now, firmer inflation in the US is not just "noise".

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