Rising Inflation Could Cause The Fed To Become More Serious About Rate Hikes

Federal-Reserve

Julius Baer Research | Against all odds the US Federal Reserve (Fed) continues to show a bias towards normalising rates. Comforted by stabilising financial conditions and a pickup in inflation, the Fed will try to guide market expectations towards additional rate hikes this year.

However, the US Federal Open Market Committee (FOMC) will leave rates unchanged at this week’s meeting and will make no changes to its balance sheet policy.

Our baseline outlook for US monetary policy this year remains unchanged: we still expect the Fed to dodge away when it comes to another interest rate hike at the upcoming FOMC meetings − very similar to last year. But rising inflation could cause the Fed to become more serious about rate hikes. The private consumption deflator without food and energy is its main gauge to monitor price stability. This inflation measure has moved up from 1.3% last year in January to 1.7% in the same month this year. Inflation is still below the Fed’s price stability threshold of 2%, but the distance has clearly narrowed. The pickup in inflation is not necessarily in contrast to the weakness in US leading indicators, e.g. the Institute for Supply Management (ISM) index readings close to or below 50. Both manufacturing and service ISM surveys point to weakening activity. This divergence displays the lagging effect of inflation and labour market developments relative to the measures of intended economy activity.

No matter what precise connection between ISM readings and inflation exists, a rising inflation rate always has to be taken seriously by a central bank. We do not expect the FOMC to hike interest rates this week, but the Fed might want to guide the markets toward the possibility of additional interest rate hikes this year, given that inflation is moving higher. Stabilising financial conditions make it currently easier to largely ignore the cautious signals from leading indicators for economic activity.