The Federal Reserve cares a lot about inflation. As part of their dual mandate, they strive for maximum employment and stable prices. The Fed’s explicit inflation target is 2%, in the medium-term, as measured by the PCE (Personal Consumption Expenditures) Index. This 2% target is “symmetric” meaning that policy makers should treat deviations above and below their target with similar urgency. Inflation expectations also play an important role in monetary policy so they look for stability in these measures as well.
The various factors that shape the Fed’s view of inflation include:
Each of these inputs allows the Fed to create an outlook for inflation which helps guide their monetary policy.
What we have seen recently is a divergence among many of these factors. This divergence has made the Fed’s view of inflation more complex.
Core inflation has been running strong due to strength in core services, including shelter, and the diminishing effect of a strong dollar on core goods. February Core CPI came in at 2.3% YoY, the strongest level in the recovery since ’08. January Core PCE, which came in at 1.67% YoY, exceeded the Fed’s year-end forecast of 1.6% for the end of 2016. Even better, the acceleration in both these measures was relatively broad-based. The steady improvements in the labor market should positively impact wages and further boost the core measure.
While core inflation has been robust, headline inflation remains depressed by oil prices and has dragged market-based breakeven rates along with it. The market-based measures, such as TIPS breakeven and inflation swap rates, have declined precipitously since late 2014, along with the energy market. The Fed has asserted that recent market-based inflation rates do not reflect an accurate measure of true inflation expectations because they are impacted by market technicals, liquidity premiums well as swings in oil prices, which they considered as transitory factors. The survey-based measures, which they consider an indicator of consumer sentiment and inflation outlook, have stayed relatively stable at or slightly above 2.5% which is consistent with their target.
So what can we expect from the Fed when various measures of inflation indicators are pointing in different directions? In light of recent improvements, market participants were expecting a more balanced tone around inflation at the March FOMC meeting. Instead, the statement came as a surprise with a dovish bias and heightened concern around inflation.
Although the statement recognized the pick-up in inflation over the past few months, their median forecast for core PCE was revised downward along with their expected path for the federal funds rate and their growth outlook in 2016. At the press conference to follow, Chair Yellen’s tone was even more cautious. She was unconvinced that this uptick in inflation would last, stating “So, I’m wary and haven’t yet concluded that we have seen any significant uptick that will be lasting in, for example, in core inflation.”
It seems that the Fed is not yet convinced about the recent firming of domestic indicators and appears more concerned about the effects of global economic weakness and financial markets volatility. Chair Yellen’s caution indicates to us that the burden of proof has been ratcheted even higher. What it will take, we are not certain. But we can certainly expect them to continue to surprise the market with the unexpected.