US: Inflation pick-up to narrow the gulf between Fed and market interest rate expectations - ING

In view of James Knightley, Chief International Economist at ING, the combination of falling inflation, weak wage growth and 'mixed' activity data have led financial markets increasingly to doubt the prospect of Federal Reserve interest rate hikes.

Key Quotes

“The lack of progress on either the tax reforms or the infrastructure spending splurge President Trump promised hasn’t helped either.”

“However, we are now at the point where the difference between what the Fed believes it will have to do to achieve its dual mandate (maximum employment and 2% inflation) and what the market believes the Fed will implement has become a vast gulf.”

“For now, FOMC members believe they will have to raise rates once more this year with three further 25bp rate hikes in 2018. In contrast, interest rate futures are pricing in barely one rate hike over the next eighteen months. It looks as though it the lack of price pressures in the economy that is the main reason for the divergence.”

“Weaker dollar starting to drive up prices

There are other signs of pressure too. Both last week’s ISM reports saw decent upticks in their prices paid components, while import price inflation has swung back into positive territory after falling 10% in 2015 and 3% in 2016. The dollar’s 10% decline since the start of the year could further boost the price of imported products.

The rapid ascent of oil prices in recent weeks will also add fuel to the fire.”

“Watch out for higher CPI this week

This week will see the release of the PPI and CPI reports and both look set to show an increase in inflationary pressures. The market is currently looking for headline PPI to rise to 2.3% from 2% (core PPI to rise to 2.1% from 1.9%) while Friday’s CPI report is predicted to show headline inflation rising to 1.8% from 1.6%. We expect it to be back above 2% by the end of the year.”

“Our view

This combination of stronger wage, producer and consumer price inflation could nudge the market into thinking it's pricing of only one rate rise over the next 18 months may be too cautious. Moreover, with the output gap shrinking in the US and inflation widely expected to drift higher, we suspect the Fed will remain wary of leaving policy too loose for too long.

With the activity, backdrop looking reasonable and the economy adding jobs in significant numbers, plus the potential for a positive surprise on tax reform, we are looking for a December Fed rate hike followed by two further moves next year.”