The Fed could surprise people in September

The Federal Reserve looks all but set to raise interest rates at its next policy meeting on June 13-14, and officials have indicated at least one more hike is coming before year end.

Dallas Fed President Robert Kaplan was the lastest to chime in, arguing the Fed would likely raise interest rates twice more this year in addition to making a widely expected announcement about gradually reducing its $US4.5 trillion balance sheet.

However, one seasoned Fed watcher thinks low inflation, which continues to undershoot the central bank’s 2% target, will prevent a September move.

Julia Coronado, president and founder of MacroPolicy Perspectives and a former Fed economist, says “there does not appear to be an elevated risk of overheating and the Fed will likely struggle to meet its inflation mandate despite a healthy job market.”

For this reason, she writes in a research note, “I continue to expect one more rate hike in June followed be a pause in September and a balance sheet policy announcement in December.” That’s a deviation from the market consensus, which is still counting on another hike in September. Markets have come to write-off meetings that do not contain press conferences as unlikely to contain major policy decisions, despite policy makers reassurances that every meeting is “live.”

US unemployment has fallen sharply from a Great Recession peak of 10% in October 2009 to just 4.4% in April. However, subdued inflation and, specifically, a lack of wage growth suggest the job market still has room for improvement.

The Fed’s preferred inflation measure, the personal consumption expenditures index or PCE, moved further below the central bank’s target to 1.7% in the year to April, while prices excluding food and energy slipped to just 1.5%.

“The Fed is falling short on inflation, and policy decisions are likely to lean toward shoring up commitment to their inflation mandate,” argues Coronado. “The message in June is likely to be steady as she goes with the Fed on its stated plan, but the shortfall in hand on inflation at that point will have to be acknowledged leaving the door open to a pause.”

Coronado’s argument was bolstered by a speech by Lael Brainard, an influential Fed board governor, May 30.

“I see some tension between signs that the economy is in the neighbourhood of full employment and indications that the tentative progress we had seen on inflation may be slowing,” Brainard said. “If the tension between the progress on employment and the lack of progress on inflation persists, it may lead me to reassess the expected path of the federal funds rate in the future, although it is premature to make that call today.”

It wouldn’t be the first time the Fed’s optimism about its ability to tighten monetary policy would prove unwarranted. For several years now, policy makers have started the year forecasting growth of as high as 3% and talked up several rate increases, only to retreat their posture as the economy’s performance remained tepid.

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