Fed: Rising CPI inflation likely to be ignored - MUFG

Derek Halpenny, European Head of GMR at MUFG, notes that the USD has remained broadly underpinned going into the FOMC meeting on Wednesday with a widely held view that instead of a ‘dovish hike’ the markets were expecting prior to Governor Brainard’s speech last Monday, we will now get something more akin to a ‘hawkish hold’. 

Key Quotes 

“The economic data of late is probably enough for the FOMC to justify caution this week and certainly it is difficult to envisage the FOMC believing a hike is urgent enough when market probability implies a less than 10% chance of a rate increase on Wednesday. So while the numbers for a rate increase seem to be there if you assume Yellen, Fischer and Dudley wanted to go, our guess is that these key three FOMC members no longer want to hike like they probably did just a few short weeks ago.

When looking at the very recent activity data there are signs of some slowdown but after the CPI data on Friday it is more difficult to understand the continued concerns expressed by some FOMC members about “too low inflation”. The CPI data on Friday revealed another upside surprise with the annual core CPI rate accelerating from 2.2% to 2.3%, the highest level since February, matching the cyclical high to date. Housing and shelter were factors in the move higher but importantly medical care also played a notable role in the uptick. Medical care jumped 1.0% in August and 4.9% on an annual basis.

The weighting is much smaller in the CPI than the Health Care component in the PCE price data where prices have remained very subdued. The indices are measured differently but as you can see above, still tend to correlate over time and if Health Care prices in the PCE inflation data starts to follow the CPI pick-up we will quickly see the annual core PCE price index jumping. The weighting of total Health Care in the PCE data is around 18%, about three times the size of medical care in the CPI report.

But we suspect Yellen on Wednesday will continue to cite too low inflation as a reason for continued patience in lifting rates. The DOTS profile will likely signal one rate increase this year. The 1.63% median rate for end-2017 will probably be cut also given the FOMC will not want to signal the need for four rate increases next year. The long-run fed funds rate may also be lowered from the current 3.00%. If all of that materialises it seems unlikely that Chair Yellen will be viewed as being “hawkish”. Furthermore, one obvious conclusion from the FOMC’s reluctance to move even though inflation is moving higher will be that the Fed is willing to allow an overshoot of the official 2.0% target – scenario that may well lower real yields and undermine the dollar.”