BERTONCINI Sergio , Head of Rates & FX Research
USARDI Annalisa , CFA, Senior Economist
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On the Fed, inflation and growth
May FOMC: no news does not mean hawkish news
As widely expected, the Fed left its fed funds rate target unchanged at its latest FOMC meeting. The only minor move was a technical one, on the interest on excess reserves (IOER) rate. On the back of technical factors (mainly due to increased Treasury issuance and tax receipts), the effective fed funds rate has been edging higher in the last weeks, moving closer to ceiling of the target range; the Fed “reduced” this rate back vs the mid-point of the target.
Policy statement as well was largely in line with expectations, with minimal adjustments vs the previous one, confirming a more upbeat assessment on economic growth and labour markets, consistent with recent published data. In particular, the new statement upgraded the assessment on both the labour market, which “remains strong”, as “Job gains have been solid”, andoverall economic activity,which “rose at a solid rate”. At the same time, the statement underlined the dichotomy between more solid growth and weaker inflation, as “overall inflation and inflation for items other than food and energy have declined and are running below 2 percent” – basically, a sort of downgrade with respect to the March assessment.
Understandably, within this mix between stronger growth and weaker inflation, Fed Chair Powell focused on the latter at his press conference. He emphasized the temporary nature of the recent trend, as, in a nutshell, the Committee ”sees good reasons to think that some or all of the unexpected decrease (in core inflation) may wind up being transient”,with rationales mainly based on sector-specific trends.Powell’s message, based on the belief that current transitory factors keeping inflation down will subside later in the year, clearly supports a stable outlook on rates and the current patient stance with no need to move towards a more dovish stance.
Market reaction following a non-event FOMC meeting was understandably limited, with slight profit-taking in US equities, as if the Fed was not looking dovish enough, while the bond market was relatively unchanged, with 2-yr Treasury bond yield edging slightly higher. Interestingly, the probability of a rate cut implied by yearend in futures fell back to 50%, after having been priced higher for some time over the last weeks, following Fed dovish surprises.
In conclusion, after its latest meeting, the FOMC hinted at no need for a change in the outlook for monetary policy in the foreseeable future. Following the strong dovish surprises already delivered in the previous months on both rates forward guidance and QT, the Fed is likely to remain on hold for some time to come, in a data-dependent and patient approach. Markets’ implied rates for yearend seem to be more consistent with this stance, together with the recent move in the long end of the curve.
Core PCE underlying trends show that structural inflation has been recently subdued
Core PCE came in at 1.55% YoY (1.7 in February, 1.8% in January), disappointing expectations of a stabilisation around 1.7%. If we break down the contributions to core PCE, it’s evident that the main drag came from what we call “structural” components (i.e. non-reacting to the cycle), where the contribution declined significantly, due especially to the drag from few Core Durables and Non-Durables, while in general Services remained supportive. Although some of these categories have remained in deflationary territory for a while, the March decline in some categories is somewhat larger than usual and could point temporary weakness. Meanwhile, one of the categories that represented one of the major swing factors in YoY inflation, a major drag in 2017 and contributor in 2018 ( Telecom Services), should with March 2019 have exhausted the base effect (yet, net of this, it is likely to remain in deflationary territory, where it has lain since 2016).
Charts 1&2: contribution of cyclical and non-cyclical components to inflation was around 1% by the end of 2018, but since then cyclical contribution has gone higher (in line with the protracted expansion of growth), while the contribution of structural inflation has declined. In part, this decline may be temporary, although some of the categories representing a drag have been in deflationary territory for a while. It is also evident how cyclical inflation has trended towards 3%, while structural inflation has reverted to the 1% region.
Chart 3 & 4: among the non-cyclical components, Services (SERV) have mainly contributed positively to inflation, while Durable Goods (DG) and Non-Durable Goods (NDG) mainly represent a drag. Notably, one of the categories that represented one of the major swing factors in YoY inflation, a major drag in 2017 and a contributor in 2018 (Telecom Services), which was often cited by Janet Yellen as one of the temporary drags on inflation, should in March 2019 have exhausted the base effect that lifted 2018 inflation (yet, net of this, it is likely to remain in deflationary territory, where it has lain since 2016).