Fed hikes interest rates despite soft inflation

The central bank also surprises markets with a plan for balance sheet unwinding

Jun 14, 2017 | Invesco Fixed Income

As was widely expected, the Federal Reserve (Fed) hiked its benchmark interest rate by 25 basis points today to a range of 1% to 1.25%. While the rate rise was almost 100% priced into the bond market, the Fed’s formal statement leaned hawkish with the unexpected announcement of a plan to scale back its asset reinvestment program by not replacing assets as they mature. The market had not been expecting an announcement on the Fed’s “balance sheet unwinding” plan for another several months.

Ahead of this surprise, bond yields had tumbled earlier in the day due to a weak inflation report showing that the consumer price index (CPI) fell by 0.1% in May, the second decline in three months and the third major downside surprise in a row.1 This brought annual inflation to 1.9%, down from a peak of 2.7% in February.The soft inflation report came on the heels of a disappointing May employment report that showed that the economy added only 138,000 jobs in May, well below consensus expectations and below the long-run average of around 180,000 jobs per month.2

Today’s Fed decision to raise rates and scale back reinvestment later in the year shows that it “saw through” these weak data points. The Fed’s economic projections and the so-called “dot plot” of the Federal Open Market Committee’s (FOMC) interest rate forecasts revealed that, from its perspective, not much has changed in terms of economic fundamentals. The Fed’s median projection of an important measure of inflation, growth in the core personal consumption expenditures (PCE) price index, fell from 1.9% to 1.7%, which is below the Fed’s target of around 2%. However, the 2018 and 2019 projections remain unchanged.

What’s in store during the second half of 2017?

The rate hike decision is, in our view, recognition of the US economy’s solid performance over the past year and a vote of confidence in its solid growth prospects, which we also foresee. But these data do raise questions over trends in employment and inflation going forward and Fed policy in the second half of the year. Will the Fed raise rates one more time this year, as it had previously penciled in? And, when, exactly, will it begin to scale back reinvestments?

At Invesco Fixed Income, we expect overall growth to remain healthy and maintain our forecast of 2.3% to 2.5% trend gross domestic product (GDP) growth over the next year. Some major drivers of recent lower-than-expected inflation reports have been statistical in nature or due to an oversupply of certain core goods, such as used cars. Falling rents have also been a factor, but we believe housing demand remains strong, especially among millennials. We expect the core PCE price index to rise by 1.7% by year-end. Looking further ahead, we expect inflation to rise significantly in 2018, as many of the statistical and supply-driven factors stabilize and rents begin to move up again.

We believe a third rate hike this year is still in the cards — likely in December — but if a better inflation outlook does not materialize by December, we could see a pause in rate hikes through mid-2018. Our base case is for the Fed to start scaling back its reinvestment plan in September. There is one looming uncertainty that could potentially hinder a September announcement: the debt ceiling. If markets react adversely to a lack of resolution on the debt ceiling debate by the September FOMC meeting, the Fed could wait until December to implement its reinvestment plan in order to limit potential market disruption.

All in all, we continue to expect the Fed to proceed with its policy normalization as planned: one more rate hike this year and balance sheet reduction at a slow, gradual pace. We are carefully watching inflation, as continued price declines could derail our view. However, we believe we are most likely to see a continuation of stable, low inflation and moderate growth over the medium term. An environment of low inflation and steady growth could help elongate the credit cycle and provide room for the Fed to maintain its easy monetary stance for longer, which we believe sets up a supportive environment for credit assets.

1 Source: US Bureau of Labor Statistics, June 14, 2017. February peak reported March 15, 2017.

2 Source: US Bureau of Labor Statistics, June 14, 2017. According to the bureau’s website, the monthly gain in total non-farm payroll employment averaged 181,000 over the prior 12 months.