Bets on the timing of the Fed's rate hike have been at the fore of currency traders' minds in recent months, but market participants have been left vexed by economic data that provide an inconsistent snapshot of the US recovery.
With US unemployment rate falling to 5.6% in December, compared with 6.6% in February 2014, the Fed's attention has turned to the outlook for inflation, which remains low. The US central bank has a 2% medium-term target and a dual employment/inflation mandate. CPI inflation, however, is at 1.3%, core is 1.7% and the personal consumption expenditure (PCE) index – the Fed’s preferred inflation gauge – fell to 1.2% in November compared with 1.4% the previous month.
Minutes from the last Federal Open Market Committee meeting suggest the Fed is relatively relaxed about inflation whereas concerns over the strength of the US recovery remain central to policymakers.
“From a tactical perspective, the Fed needs to start raising rates when growth is strongest, but it doesn’t want to move too early and then have to reverse course,” says William Lee, head of North America economics at Citi.
This is where the benefit of the low oil price kicks in. “We estimate the net benefit to the economy at the lower price to be approximately $140 billion per year,” says Lee.
Lee says: “The only growth we see in the US at the moment is the result of the low price of oil...It is only a matter of time before the economy finds its new equilibrium. It could be 12 or 18 months, but at some stage growth will fall back to the trend rate of 2% to 3%.”
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Source: Standard Chartered |
If the precipitous drop in the price of oil in the last six months has done more to put downward pressure on US inflation – and an upward boost for growth – than any other single factor, the future path of the oil price will be crucial in determining future inflation.
Lee says: “At the moment projections for the future oil price are changing almost by the minute, and so too are the growth forecasts. If you look at consumption, investment, the economy and the exchange rate, every factor has considerable downside risk. The only one that doesn’t is the oil price, and that is the one that will get the Fed to move.”
In December, Citi's 2015 average oil price forecast was $75 to $80 a barrel, but it has since been revised down to $50 for the first half and only up to the $60s level by the end of the year. Standard Chartered still officially expects oil to rebound to an average price of $85 for the year.
What certainly would spook the Fed would be a further decline in inflation. And a falling oil price is not the only potential source of such disinflationary pressure.
Michael Gapen, head of US economics research at Barclays, says: “Services inflation ex-energy was up 2.5% for the year through November and accounts for around 57% of consumer prices. Whereas core goods inflation, many of which are imported, fell 0.5% and accounts for 19% of consumer prices.”
Specific sectors are contributing to the downward pressure for different reasons. University tuition fees are dropping in response to slowing attendance growth, while medical prices have slowed since the Patient Protection and Affordable Care Act or Obamacare was implemented, says Thomas Costerg, US economist at Standard Chartered.
Michael Hanson, senior economist at BofA Merrill Lynch Global Research, says while imported deflationary pressure from the eurozone is a risk for the US economy, “most Fed officials seem to be comfortable discounting those concerns for now,” and are focusing instead on domestic growth in activity and employment, which should push inflation towards its target.
“The US on its own is reinflating and it should be enough to offset falling import prices from the rest of the world,” says Gapen at Barclays. “At times like this it is an advantage to the US that it has a relatively closed economy.”
Lee says there is no great risk of inflation rising above the Fed’s 2% target in the US until 2016 at the earliest, and possibly as late as 2018. “But the current level of inflation is only half the story, equally important to the Fed is the forecast of a rise, which would mean the economy is in robust health. It is this expectation of growth that underpins the Fed's actions,” he says.
Gapen says: “The five-year five-year breakeven inflation rate should be free of any transitory energy price move, so the sharp decline in this measure below 2.0% indicates this is much more than just an oil story.”
The Fed has been a little dismissive of market-based measures for inflation expectations, such as the five-year breakeven rate, which is at 1.1%, and the five-year five-year rate, which at 1.85% is the lowest it has been since 2000.
“The Fed argues these measures are too easily distorted by issues such as liquidity and technicalities, but we believe it will ultimately have to consider these measures, meaning it will likely hold off raising rates until September,” says Costerg.
This fall in inflation expectations may be less about actual expectations than the increase in the risk premia associated with such a fall, says Lee – and the Fed may have come to a similar conclusion.
This all leaves analysts predicting rate hikes in the second half of the year at the earliest. Costerg at Standard Chartered reckons September, while Citi's Lee says December. Both agree that whichever it is, the path of subsequent increases is just as important.
“The trajectory of rises will be very shallow, but the earlier they start, the more cautious the Fed will be and the shallower the rate of growth,” says Lee.
“We see the US moving from 'very accommodative' to just 'accommodative', but it will move very cautiously as it does not want a repeat of the QE taper tantrum in 2013,” says Costerg. “The upcoming tightening cycle will be very gradual – unless there is a huge shift in the GDP or inflation data – and assuming inflation rises very gradually too.”