Easier Financial Conditions Will Keep the Fed on Track

The path laid out by the Federal Reserve at the beginning of the year for three interest-rate increases plus the start of reducing its $4.5 trillion balance sheet looks shaky due to the slowdown in inflation. There’s no question that the Fed is nervous about the persistent inflation shortfall. Chair Janet Yellen made note of the issue during her congressional testimony earlier this month.

That said, the Fed will balance the inflation data against the broader economic backdrop of ongoing job growth and easier financial conditions. If the latter two trends continue, policy makers will be hard-pressed to rein in existing rate hike plans even if inflation continues to fall short of their forecasts. The traditionalists at the Fed, including Yellen, retain their fundamental Phillips curve framework. They think it is only a matter of time before the Phillips curve is proved true and sends inflation higher, especially if monthly job growth remains well above the 100,000 level. They do not want to find themselves well below their estimate of the neutral interest rate should inflation accelerate.