Softer U.S. Inflation Puts Fed Tightening Ahead of Schedule

  • Weakening in price pressures has effect of raising real rates
  • Interest rates now just barely below Fed’s ‘neutral’ estimate

A surprise slowdown in U.S. inflation so far this year is tightening monetary conditions a lot faster than Federal Reserve officials wanted.

Inflation data released Wednesday in Washington by the U.S. Labor Department showed the so-called “core” inflation rate, a closely watched measure of the underlying inflation trend that excludes volatile food and energy components, softened to 1.7 percent in May, down from 2.3 percent in January.

That means inflation-adjusted, or “real,” interest rates have gone up about half a percentage point this year purely due to declines in the rate of inflation. That doesn’t include the actual rate increase that the U.S. central bank’s policy-setting Federal Open Market Committee delivered in March, nor the hike it authorized on Wednesday.

Add those two rate increases to the decline in inflation, and real interest rates have effectively increased by a full percentage point this year so far. The distinction between real and nominal rates is important because Fed officials measure how much stimulus or restraint they are providing based on an assumption about what the “neutral” rate of interest is in real terms.

The most popular estimate of the so-called neutral rate, which neither spurs nor brakes the economy, is produced by the Federal Reserve Bank of San Francisco, based on work by Thomas Laubach -- a key official at the Fed’s Board of Governors in Washington -- and San Francisco Fed President John Williams.

Their latest estimate is that, as of the end of 2016, the neutral rate was just 0.03 percent. The FOMC on Wednesday raised the target range for its benchmark federal funds rate to 1 percent to 1.25 percent, just below where the latest data puts core inflation.

According to quarterly projections updated for Wednesday’s meeting, officials see short-term real interest rates at -0.3 percent by the end of this year, rising to 0.1 percent by the end of 2018, adjusted by forecast inflation at that time. In March, the median estimate was for -0.5 percent real rates through the end of this year.

“With policy accommodative, all that we’re doing in raising rates is removing a bit of accommodation, heading toward a neutral pace, and I see that as appropriate," Fed Chair Janet Yellen said in a press conference following the FOMC meeting.

Fed Forecasts

While they are broadly following the path outlined in their projections for the nominal interest rate, meeting the inflation side of the real-rate projection this year is beginning to look difficult. If the FOMC sought to provide the same amount of stimulus as before, it would have had to adjust what it considers to be the appropriate path for nominal rates lower until inflation bounces back.

Though Yellen and her colleagues didn’t signal that on Wednesday, investors are still betting they will do just that, pricing just 1.5 rate hikes through the end of next year, versus the median FOMC participant’s projection of four increases over that period.

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