A third important factor in the Fed’s inflation forecast is pressure on resources, in which we have seen some of the biggest surprises in prices during the economic recovery. Supply chain disruption has contributed greatly to increased prices in things such as durable goods. Consumer demand has surged for goods such as autos, home appliances and furniture and this is probably the most troubling area of inflation for the Fed, which recently admitted that a forecast error could potentially occur since we have not experienced an inflation cycle that is currently taking place. However, the Fed also likes to use the Trimmed Mean PCE inflation rate as an alternative measure of core inflation for personal consumption and perhaps not too surprisingly the index has been very well behaved. In calculating the trimmed mean, the goods and services with exceptionally large or small price movements in a given month are dropped from the calculation.
Repricing the US yield curve
In spite of these three factors mostly giving the Fed comfort that their policy is set at the right level within the average inflation target structure, the central bank, with a slightly hawkish tilt, certainly raised its concern about inflation at the June Federal Open Market Committee (FOMC) meeting. This slightly hawkish tilt was evident in the rate forecasts produced by each Fed official that make up the Dot Plot. In their forecasts,seven members see the first hike coming in 2022 compared to only four in the March forecast. For 2023, 13 Fed members forecast rate hikes, up from seven in the March forecast. This bringing forward of forecasted rate increases caught the market by surprise given the Fed’s recent comments about policy being appropriate. However, at the same time the bringing forward of forecasted rate increases seems to be more in line with market expectations for Fed hikes. It is also somewhat surprising that the Fed has not spoken about reducing QE purchases and yet the officials, in moving forward their rate hike expectations, are likely to be concerned that inflation may prove to be more than transitory unless the central bank does something to contain it.
Since the FOMC meeting the market has begun to reprice the US yield curve and we have seen a sharp flattening of the 5-year to 30-year part of the US curve. This seems to indicate that the market still believes the Fed has the capacity and credibility to influence rates through transparency in order to control inflation. The surprising thing is the Fed talks about sequencing how it will shift to remove easy monetary policy and the first step being a taper of asset purchases. The Fed will likely give the market guidance about its QE plan at its September meeting, with inflation measures at the time likely to determine how aggressively it opts to reduce purchases. But one thing seems clear: as the Fed removes the emergency easing, the US interest rate curve needs to continue bear flattening with the rise by short term interest rates outpacing the rise by longer rates if interest rates are to get back to pre-pandemic levels.
