Yellen's `Uncertainties' Could Imperil Fed's 2015 Liftoff

Yellen: Controlling Inflation Is Crucial to the Fed
  • Inflation, global outlook and market volatility may not clear
  • Fiscal showdown could also erupt just ahead of December FOMC

The Federal Reserve held interest rates near zero last week, though 13 of 17 policy makers still expect a rise this year. That forecast faces a major threat: The concerns that persuaded officials to delay action are just as likely to escalate over the next three months as to die down.

Financial market turmoil, slower global growth and lingering doubt about the path of inflation led the central bank to postpone its first rate rise since 2006, according to the Fed’s statement last Thursday. Chair Janet Yellen told the post-meeting press conference that “in light of the heightened uncertainties abroad and a slightly softer expected path for inflation, the committee judged it appropriate to wait for more evidence.”

Those headwinds could abate in time for officials to lift off at their meeting in either October or December, but should they worsen, it may kill all hope of an increase in 2015.

Inflation Hurdles

Exhibit A: There are several reasons why inflation might continue to languish or even soften further before the end of the year, causing it to fall short of the Fed’s already modest 0.4 percent 2015 estimate.

Declining unemployment may fail to push up wages as the Fed expects because of hidden slack in the labor market. Tumbling oil prices, while not measured in core readings of inflation, could pass through to other prices. And a stronger dollar could cool inflation further by dampening the cost of imports.

Though the Fed often cites the dollar and commodity prices as headwinds that it views as transitory, they might not be the only things contributing to subdued price pressures.

"If this were the main story, we should be seeing the weakness much more concentrated in core goods than in core services," Goldman Sachs Group Inc. economists wrote in a Sept. 18 note. Instead, "core services inflation is meaningfully below normal.”

To be sure, the Fed says it just wants to be “reasonably confident” that inflation will move back up toward its goal before raising rates. Also, Yellen has said that persistent labor market improvement would help to encourage her belief that price pressures will bubble up, and the jobless rate has fallen to 5.1 percent, the lowest since April 2008 and near to Fed estimates of full employment.

Still, it’s hard to see how still-subdued or even weaker inflation data would bolster the faith of officials that it’s finally on the right track.

International conditions could worsen

Concern over a slowdown in China and other major developing economies has roiled financial markets since mid-August and contributed to the Fed’s decision not to lift off this month.

"We’re asking ourselves how economic and financial developments in the global economy affect the risk to our outlook for our two goals and whether or not they create unbalanced risks," Yellen said last week, calling the dual mandate of stable inflation and maximum employment the "filter" through which the Fed is viewing global economic uncertainty.

The trouble is, the central bank may gain little clarity between now and year-end if the global situation worsens. The Asian Development Bank cut its growth forecast for the region’s developing economies in a Tuesday release. It downgraded China’s economic outlook for the second time in just over two months -- to 6.8 percent in 2015 and 6.7 percent in 2016. That was down from July estimates for 7 percent growth this year and 6.8 percent next year.

"It will likely take some time to sort out whether Asia is going into a hard landing and how that plays out in the U.S.," Ethan Harris, co-head of global economic research at Bank of America Corp. in New York, wrote in a research note. Even so, he thinks the Fed will be able to raise rates in December based on domestic strength. 

Citigroup Inc. economist William Lee, who has shifted his liftoff call to spring 2016, disagreed. “It will likely be next year before we can dissipate significantly the uncertainties stemming from China and the related slowdown,” in emerging-market economies, he wrote in a research note.

It’s also worth noting that Asia isn’t a lone shadow on the international horizon: Canada, the U.S.’s largest export market, is forecast to post 1.1 percent growth in 2015, the slowest since a 2.7 percent contraction in 2009, according to economists surveyed by Bloomberg.

Market volatility is still an issue

As measured by the Chicago Board Options Exchange volatility index, markets remain pretty jumpy. Fed officials don’t care much about market tumult on its own. They do care if it upsets business and consumer sentiment and ripples to the broader economy.

“Market volatility can be a symptom of more fundamental ills,” Atlanta Fed President Dennis Lockhart said on Monday. “And market volatility, if protracted, can be a channel for damping forces on economic activity.”

If some combination of the slowdown in Asia and concern about the timing of Fed liftoff are what’s spurring market volatility, then there’s a real possibility that it won’t fade quickly.

“Increased uncertainty continues to leave the Fed’s decision-making function more opaque, increasing market volatility as investors react to any further news of slowing global growth momentum,” Gennadiy Goldberg, U.S. rates strategist at TD Securities in New York, wrote in a Wednesday research note.

Bonus headache: fiscal showdown

The chances of a U.S. federal government shutdown due to a funding lapse is probably around 50-50, Goldman Sachs’ Alec Phillips estimated in a Monday note to clients. The nation is also likely to reach its debt limit in November, with the Treasury running out of options to avoid breaching the borrowing ceiling by early December, he estimates.

“You could have a government shutdown and a need to raise the debt limit bump up against each other right around the time of the meeting,” said Omair Sharif, rate sales strategist at SG Americas Securities LLC in New York. “The shutdown itself is really not much of a concern,” he said. “The debt limit is a much, much bigger deal.”

Before it's here, it's on the Bloomberg Terminal. LEARN MORE