Fed Rate Increase Seen Mid-Year Even as Inflation Is a No-Show


JANUARY 01, 2015

WASHINGTON, DC - DECEMBER 17: Federal Reserve Board Chairwoman Janet Yellen speaks during a news conference December 17, 2014 at the headquarters of Federal Reserve Board of Governors in Washington, DC. The Federal Reserve announced that it will not increase target funds rate for now.   Alex Wong/Getty Images/AFP == FOR NEWSPAPERS, INTERNET, TELCOS & TELEVISION USE ONLY ==

Economists are slashing US inflation forecasts for 2015 as oil prices tumble. What is not changing are predictions that the US Federal Reserve will raise its benchmark interest rate anyway, probably around mid-year.

“We’re still saying June with risks to September,” said Michael Gapen, the New York-based chief US economist for Barclays. The Fed “can push rates higher in the middle of the year, even though visually that may look awkward if headline inflation is around zero,” he added.

A stronger dollar, slowing global growth and cheaper oil are holding down costs for goods such as televisions and cars. Fed policy makers will probably look past that and see an improving labor market that will force employers to offer higher wages. Those costs will soon push up the price of such things as rent and restaurant meals, no matter what happens overseas, giving the central bank room to raise interest rates that have been stuck near zero for six years.

Barclays economists predict the personal consumption expenditure, or PCE, price index that is the Fed’s preferred measure will be up 0.5 percent in the second quarter from the same time in 2014. That is down from a previous forecast of 1.2 percent. The consumer-price index, a separate gauge, is projected to show a small decline in the 12 months through June.

The Fed’s goal is for PCE inflation to climb around 2 percent a year.

Core prices, which exclude food and fuel, will rise 1.7 percent over the same period, according to the analysis by Barclays. That compares with a previously estimated 1.9 percent.

Services inflation

“Low pass-through into core from falling energy prices, and a gradually improving labor market leads to some wage and services inflation” this year that will help assuage any concern the United States is catching a disinflation bug, said Gapen, a former Fed economist.

Too low inflation hurts debtors by making it harder to pay off loans. Also, the longer central banks undershoot their price targets, the more their ability to deliver stability will be questioned, undermining expectations further and putting even more downward pressure on prices.

Fed chairwoman Janet Yellen and her colleagues probably will face a communications challenge as they pave the way for the central bank’s first interest-rate increase since 2006. Policy makers have said they believe the plunge in fuel prices will prove temporary, which will be more difficult to substantiate as inflation gauges keep sliding six months from now.

Yellen’s view

Energy “is going to be pushing down headline inflation and may even spill over to some extent to core inflation,” Yellen said in a Dec. 17 news conference after the central bank’s policy meeting. “But at this point, although we indicated we’re monitoring inflation developments carefully, we see these developments as transitory.”

An improving economy and labor market will help “inflation to move gradually back toward its objective,” she said.

The Commerce Department reported last week that the core PCE price index climbed 1.4 in the year ended in November, which means Barclays is still projecting it will move toward the Fed’s goal, but just take longer to get there.

That is probably enough from central bankers’ perspective to prompt a rate increase, said Omair Sharif, an economist with Newedge USA, a New York-based brokerage firm.

“It may take three years to get back to 2 percent, but as long as we’re not going back to 1 percent, they seem OK with it,” Sharif said.

Regional Fed bank gauges are signaling inflation will be slow to accelerate. The Dallas Fed’s “trimmed mean” index, which eliminates the components in the PCE price gauge that show the biggest changes in any month, increased 1.6 percent in November from a year earlier, holding within the 1.6 percent to 1.7 percent range it has been in since April.

Including food and fuel, the PCE price index rose 1.2 percent in the 12 months ended in November, the smallest gain since March, according to Commerce Department figures issued last week. The rule of thumb is that it will converge toward the trimmed mean reading over the next 12 months, pointing to a gradual pickup, according to the Dallas Fed’s report.

The Dallas measure featured the biggest one-month drop in goods prices excluding food and fuel in data dating back to 1977, according to the report. It was “fairly broad-based,” with clothing and footwear, furnishings and household durable equipment, and recreational goods and vehicles all showing price declines of about 10 percent at an annualized rate, senior economist Jim Dolmas wrote.

Services costs

Meanwhile, core services climbed at an annualized 2.4 percent in November, exceeding the 2.2 percent advance over the past year. The increase was paced by gains in the costs of paramedical services, rent and dining out, the report showed.

Economists at Goldman Sachs are among those forecasting that core inflation will not show signs of moving toward the Fed’s goal this year as the upward pressure on prices from an improving economy will be more than offset by the impact of the drop in oil and stronger dollar. An appreciating currency makes goods produced by the nation’s trading partners less expensive to US shoppers.

The Goldman economists maintain that September will be the most likely month for the Fed to begin raising rates even as they now project the core PCE price index will rise 1.3 percent by the second quarter, down from a prior estimate of 1.5 percent.

Goldman’s view

If it is lower than 1.5 percent by June, as they predict, and wages show only a modest pickup, then the central bank will probably hold off, Jan Hatzius, Goldman’s New York-based chief economist, wrote in a Dec. 26 note. Should inflation undershoot even their below-consensus forecast, the Fed could wait until 2016, he said.

While Barclays’ Gapen acknowledges a rate liftoff could be delayed, the Fed has to make decisions based on where policy makers think the economy and inflation will be in 12 to 18 months, he said. And by June, the jobless rate already will be close to the 5.2 percent to 5.5 percent that Fed officials say is consistent with full employment, a sign bigger pay increases are in store.

“If you can run the domestic economy hot enough, then you can have services inflation that offsets a weak global backdrop,” Gapen said. “What we would be looking for is just broad-based services inflation related to wages.”