Expert View: The Fed talks tough, but that doesn't mean a rate hike

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The Independent Online

In recent weeks, business headlines have fixated on the inflation threat to the US economy, with the investment community responding accordingly. Investors have gone from expecting the Federal Reserve Bank to cut rates in the months ahead, to talking up the prospects of further rate hikes. However, the evidence on inflation is not entirely convincing. And it would not be surprising to see the rate-cut view swing back into favour in the months ahead.

Headline inflation in the US plummeted from more than 4 per cent as recently as July, to only 2.1 per cent in the latest September reading, and should fall further in the months ahead as crude oil price declines filter through to consumer prices. But as far as interest-rate policy is concerned, the key inflation measure is that of core inflation, excluding food, tobacco, alcohol and, of course, energy.

Core inflation has risen every month since February this year, from 2.1 per cent to 2.9 per cent, well above the Fed's comfort zone. Indeed, accompanying its decision last week to leave rates on hold again, the Fed statement reiterated concern over high core inflation. Earlier in the week, it was reported that Federal Reserve staff forecasters had also downgraded their estimation of potential US growth, suggesting that spare capacity was lower and, therefore, inflationary pressure higher than previously thought. Rising wage growth has also raised concerns that inflation was beginning to embed itself into the economy.

So is the heightened anxietyjustified? And are investors right to be bracing for further rate hikes? We think not. Consider spare capacity, or "output gap" to use the economic jargon. Most models of inflation are built around the concept of an output gap. But in practice, market economists (and central banks) simply do not know how big such gaps are. The only foolproof way of knowing that interest rates have been tightened enough, and that spare capacity is again being created, is the core inflation rate itself beginning to fall.

And this is essentially where investors are missing a trick. Rates of inflation and rates of wage growth are somewhat backward looking. Today's high rates of core inflation largely reflect steeper-than-usual price increases a year ago. More recently, the core consumer price index has risen at a slower pace. But because of its earlier gains, the year-on-year inflation rate has kept going up. Less backward-looking measures show that the trend in core inflation has been easing since May, and it will not be long before conventional measures begin to drop too. The same is true of wage growth, which should show a declining year-on-year growth rate in the months ahead.

So where does that leave the Federal Reserve's tough words on inflation? Cynics might suggest that, "They would say that, wouldn't they?" The Fed is, after all, a central bank, and sounding tough on inflation is all part of the job. Moreover, there seems to be a distinct difference between what Fed officials are saying about the risks of inflation in public, and what the minutes of their policy meetings indicate when they're behind closed doors.

Such double-speak is no doubt deliberate, as tough talk is every bit as useful as rate hikes in keeping inflation under control, through its effect on expectations and longer maturity bond yields, which influence the cost of borrowing.

Admittedly, most Fed governors probably do not expect to be voting for rate cuts in the near future. But then, like many analysts, they probably have not fully factored in an imminent peaking of core inflation or of wages growth. Combined with the growing evidence of a broad US economic slowdown, which has been led by a dramatic deterioration in the American housing market, a change in both the market and the Fed's outlook for inflation and rates is probably not as far away as many investors think.