|Janet Yellen, Federal Reserve|
How and when the world’s central banks extricate themselves from the extraordinary monetary easing that has taken place over the last decade has become the debate of the summer.
The backdrop to this is the presumption that the Fed will hike rates again in September and that Mario Draghi at the ECB is turning his attention to how and when he might do the same.
The complacency of this position was, however, thrown into doubt in mid-July after inflation missed its fourth consecutive target in the US. The consumer price index rose an annualized 1.6% in June – down from 1.9% in May and lower than the 1.7% that had been forecast. Inflation in the US is now down from a five-year high of 2.7% five months ago: the debate has moved rapidly from what the pace of tightening by the Fed might be to whether or not it will tighten at all.
“I do believe part of the weakness in inflation reflects transitory factors,” declared Janet Yellen when the June inflation figures were revealed on July 12 – seeming to indicate that she will press on with rate hikes as expected.
“I well recognise that inflation has been running under our 2% objective,” she conceded, adding gnomically but added that “that there could be more going on there”.
Yellen says that there is “uncertainty about when – and how much – inflation will respond to tightening resource utilization” and that this will remain a key focus for the Fed in the near term.
Investors that Euromoney spoke to in July expressed a certain bemusement at the Fed’s position.
“It seems that the Fed is intent on continuing with the hiking cycle, which looks odd given that there have been four CPI misses,” mused one. “They are operating with a slightly different agenda. Their models are now flashing amber because of employment figures.”
US wage growth is now below the 4.7% non-accelerating inflation rate of unemployment (NAIRU) rate at which inflation should be triggered: unemployment stands at 4.3%. Either the NAIRU rate is wrong or there are one-off reasons to explain the sluggishness of inflation. Given that there have now been four CPI misses, perhaps that would need to be a four-off reason.
Markets hate uncertainty so, is there now greater concern over whether or not the Fed will even stick to its rate-hiking agenda or how that agenda will play out?
“We are beginning to see the implications of an academic and model-driven Fed,” one portfolio manager observes. “They will continue hiking even though inflation is not there because they believe they have everything in place to deliver inflation. Whether or not that is correct, we will only see in a few quarters time. It could be a policy mistake.”
Others argue that the inflation figures are being overemphasized.
"I think that they will press on with hiking because they have such a moderate path of tightening ahead of them that there is not much impact," says one investor. "It is important to contextualize what the Fed are doing – the market is getting very caught up with benign CPI prints. This is creating distortion both downwards and upwards, and the Fed is trying to look through that. It is not setting policy on the basis of current CPI prints."
After its recent three 25-basis point hikes, the Fed is expected to hike a further 50bp and start to reduce the central bank’s $4.5 trillion balance sheet by the end of 2017, perhaps as soon as September. In anticipation, investors are positioning themselves for inflation that, so far, stubbornly refuses to materialize.
With Gary Cohn warming up in the wings to possibly take over from Janet Yellen in February next year, the course of balance-sheet normalization at the Fed looks more unpredictable than ever.