Fed Watch: Fed Not Ready to Declare Victory on Inflation

Tim Duy says the Fed is not quite ready to give up its inflationary bias:

Fed Not Ready to Declare Victory on Inflation, by Tim Duy: Fed officials like to remind us that inflation remains above their comfort level, but numbers are moving in the right direction, an outlook reinforced by last week’s inflation report. Indeed, some question the Fed's ability to hold its inflation bias in the face of the recent pattern of data. From the Wall Street Journal:

The year-to-year rate is now down to just 2.2%, well off the 2.9% peak recorded in September, and raising the question of just how long the Fed can credibly continue to argue that there is upside inflation risk -- Ian Shepherdson, High Frequency Economics

I would be wary here - analysts have jumped on every chance to call an impending change in policy, only to be consistently blindsided by the Fed'€™s policy consistency. The Fed does not look at any one variable, whether it be housing, GDP, or yes, even core inflation, by itself as the key to defining future policy. For example, an excessive focus on core inflation now will miss the policy impacts of both headline inflation (it is not all about core) and the recent reacceleration of growth. Both of these point in the direction of continued inflation bias.

Headline CPI jumped 0.7% in May, but this number was downplayed given the 0.1% gain in core. Year over year, the core rate is down to 2.2%, while the 3 month annualized rate, however, has slid to 1.6%. The Fed has done such a good job of training us to look at the core that it is often forgotten that the headline rate may actually contain information about the future path of core inflation. On this point, David Altig at macroblog noted Cleveland Fed President Sandra Pianalto's recent speech, in which she expressed concern that the prolonged period of high headline inflation will eventually lead to rising inflation expectations. And other Fed officials suggest that declining core rates at this point argues for steady policy, not a jump into neutral. As Chicago Fed President Michael Moskow said in a recent WSJ interview:

Mr. Moskow, who retires at the end of August, is currently a voting member of the Federal Open Market Committee and one of its most hawkish members. His comments, however, suggest that hawkishness has been tempered a bit as core inflation by the Fed's preferred measure has dropped from 2.4% in February to 2% in April. Though he doesn't expect inflation to fall to the middle of his personal 1% to 2% comfort zone in the next year and a half, he suggested he saw little need to raise rates to hurry it up as long as "it's moving in the right direction."

Moreover, the recent reacceleration of growth after a slowdown that had arguably minimal impact on easing resource constraints will leave the Fed fretting that the recent rise in energy costs may still be passed through to the core. The retail sales numbers revealed that despite the ups and downs, consumer spending remains remarkably resilient through this slowdown. An early signal on June manufacturing from the New York Fed shows activity picking up, consistent with recent ISM figures and manufacturing orders. And while industrial production was stagnant, the Fed will look to other positive indicators in this sector and anticipate that IP numbers will perk up in the months ahead. Also, the Beige Book confirmed anecdotally the recent pick up in growth, and I tend to think the Fed will interpret the recent rise in interest rates much as Jim Hamilton does - a signal of building optimism about the path of growth.

Of course, the data are not uniformly coming up roses. If it were, we would have to start thinking about a rate hike. The Beige Book noted a widespread softening of trucking activity. I tend to think this will be rectified as the inventory correction of the last few quarters fades away. A portion of this slowdown, however, is likely related to reduced demand for housing related construction. That portion is not likely to bounce back this year, as reports on new residential construction are expected to confirm. Note however, that the Fed has come to terms with a prolonged housing slowdown. Weakness in this sector will not come as a surprise.

Bottom Line: Falling core inflation will be warmly received by monetary policy makers, and argues against any lingering thoughts of a rate hike in the next few months. But I don'€™t expect them to get all warm and fuzzy on the bias just yet. High headline inflation and reaccelerating growth will keep the Fed in a holding position for the time being.