Hurdles Higher for Future Fed Rate Hikes as Inflation Slows

  • Weaker-than-expected U.S. retail sales show consumer ‘siesta’
  • Central bank expected to forge ahead with Wednesday increase

London & Capital Sees No Reason Fed to Be Aggressive

The deepening slowdown in U.S. inflation probably isn’t enough to keep Federal Reserve officials from raising interest rates on Wednesday as anticipated, but the hurdles for further hikes just got higher.

The consumer price index fell for the second time in three months, while prices excluding volatile food and fuel had the smallest year-over-year gain since May 2015, Labor Department data for May showed. Retail sales decreased last month by the most since the start of 2016, according to the Commerce Department, though upward revisions to some figures mitigated the disappointment.

Together, the results offer an inconvenient picture for Fed policy makers assessing the economy’s capacity to handle more tightening this year as they wrap up a two-day meeting Wednesday. While some economists said central bankers are unlikely to rewrite their so-called dot-plot forecasts for additional hikes this year and next, Fed Chair Janet Yellen may indicate in her press briefing that further rate increases depend on inflation performance.

“It is too late for them to move the dots; inflation gets talked about verbally in the press conference,” said Michael Gapen, chief U.S. economist at Barclays Plc and a former Fed researcher. “If inflation does not begin to firm, a significant adjustment in the dots could be in store for September.”

The government report showed CPI fell 0.1 percent in May from the prior month following a 0.2 percent rise, and was up a less-than-forecast 1.9 percent from May 2016 after a 2.2 percent gain. While the core index rose 1.7 percent from a year ago, it has slowed for four consecutive months.

Retail sales dropped 0.3 percent from April after a 0.4 percent increase in the prior month. Purchases fell in eight of 13 major categories including motor vehicles and electronics. Sales excluding autos and gasoline were unchanged.

“The inflation numbers aren’t good and consumers are taking a bit of a siesta here,” said Ward McCarthy, chief financial economist at Jefferies LLC in New York. “The Fed is still going to raise rates today, that’s pretty much baked in the cake. But if we don’t see some firming of inflation and some improvement on the consumer side over the summer, it could slow them down” from hiking later in the year. 

Investor Bets

The Federal Open Market Committee is still widely expected to agree on a quarter-point interest-rate increase Wednesday in Washington. But investors pared bets on another hike by the end of the year, and now see such a move as unlikely, compared with roughly 50-50 odds on Tuesday.

“While softer inflation boosts real earnings growth, it also implies more slack in the economy, providing the Fed space to move even more slowly,” Neil Dutta, head of U.S. economics at Renaissance Macro Research LLC in New York, said in a note.

The disappointing core inflation readings were accompanied by details that showed a broad-based slowdown as apparel, air fares, new and used cars, and medical care services all posted declines.

Fed Statement

That signals the Fed’s “post-meeting statement will have to take the recent slowing in core inflation more seriously,” Mike Feroli, chief U.S. economist at JPMorgan Chase & Co., wrote in a report.’

Low inflation, while a challenge for the Fed, means a boost to consumers’ ability to spend. Feroli raised his tracking estimate of price-adjusted household spending for this quarter to a 3.5 percent annualized rate, from 3 percent prior to Wednesday. Economist Ted Wieseman of Morgan Stanley lifted his tracking estimate for consumption to 3.4 percent from 3 percent.

Other details in the retail report showed not everything spelled gloom and doom. Control group sales, which are used to calculate gross domestic product and exclude the categories of food services, auto dealers, building materials stores and gasoline stations, were unchanged following a 0.6 percent April advance that was revised higher from a 0.2 percent gain.

The retail sales data aren’t adjusted for prices, so lower fuel costs depress filling-station results. Besides, a strong job market, elevated sentiment and improved finances remain sources of strength for household spending, which accounts for about 70 percent of the economy.

“Despite the weakness of the headline numbers, the May retail sales data actually provide further reason to expect real consumption growth to pick up” this quarter, Andrew Hunter, an economist at Capital Economics, wrote in a note. “With consumer confidence at multi-year highs and real income growth rebounding markedly in recent months, spending growth looks set to continue at a healthy pace over the rest of this year.”

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