Metrics the FOMC Watches

November 30th, 2015 8:43 pm | by John Jansen |

This article was out much earlier today on Bloomberg and discusses inflation expectations, resource slack and commodity prices. The article suggests that since inflation expectations are reined in and commodity prices are in the crapper (my paraphrase) and only the labor market is showing signs of life,then any rate hikes are likely to be shallow.

Via Bloomberg’s Craig Torres (Click here for the graphs which accompany the article):

Federal Reserve officials have signaled that they will probably raise interest rates in December, which would mark an end to seven years of near-zero borrowing costs. Last month, officials said they needed more confidence that faster inflation was in train, especially since the central bank has missed its 2 percent target for more than three years.

To see where the Fed stands ahead of their Dec. 15-16 meeting, let’s check in with the three price indicators Fed officials are keeping an eye on, as noted in the minutes of their October gathering. Progress on these indicators is likely to weigh into decisions on future rate hikes if the Fed raises the benchmark lending rate by a quarter percentage point next month.

1. Inflation expectations

The minutes said stability in “longer-term inflation expectations” were an important element in Fed officials’ forecast for a gradual increase in inflation.

Take a look at this chart below, using data from a survey of economists conducted by the Philadelphia Fed. Respondents’ expectations for inflation over the next 10 years slumped to 1.9 percent in the current quarter, the lowest on records going back to 2007. Other survey-based measures have also drifted lower.

The good news here is that the Fed can probably afford to keep interest rates low without stoking price surges, because people already believe that inflation isn’t going to take off. The flip side of that is that “the longer inflation stays below the Fed’s target the more it is likely to feed into broader sentiment that they will continue to miss the target,” said Mike Pond, the head of global inflation strategy at Barclays Capital Inc. in New York.

This isn’t a trend that adds to the FOMC’s inflation confidence.

2. Commodities and the dollar

“Other factors important to the inflation outlook were the expectation that the influence of lower energy and commodities prices and the stronger dollar would subside,” the October minutes said.

The Bloomberg Commodity Index—which tracks everything from crude oil to copper—is down 22 percent this year. The Bloomberg Dollar Spot Index, which tracks the U.S. currency against a basket of ten global currencies, is up 9 percent.

Predicting how global demand will influence commodity prices over the next several months, or whether the dollar will maintain its appeal, is difficult. The guess work that’s required here doesn’t add to inflation confidence.

3. Resource use

Fed officials also said they would need to see the economy continue to expand “at a pace sufficient to increase resource utilization.”

Payrolls climbed by 271,000 in October, the strongest increase this year. The economy grew at a 2.1 percent annualized rate in the third quarter, and economists forecast a growth rate of around 2.2 percent in the final three months, according to the median estimate. Fed officials will get the November payroll report on Dec. 4. Estimates are for a gain of 200,000. By these indicators, Fed officials can be optimistic that a continued whittling of resource slack could firm up prices over time.

The bottom line

If this were decision-making by checklist, one out of three would mean the committee would be on hold for December. But the reality is the Fed is weighing many risks, including the possibility of financial distortions from keeping rates too low for too long. The committee sounds intent on raising interest rates. Also, Fed Chair Janet Yellen seems to put more weight on diminishing resource slack.

Even so, if the committee does raise rates in December, inflation performance could be the critical indicator that sets the pace for further increases.

“If they start tightening and then discover that inflation is heading further downward, there is a good possibility that they would just stay on hold for a while,” said Andrew Levin, a Dartmouth College professor and former adviser to Yellen.

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