Scant Inflation Puts Fed in a Box

Last Week: Interest rates pulled back from recent highs and global equities reached new peaks. The 10-year US Treasury note receded to 2.28% from 2.38% a week ago as 1-month LIBOR also fell to 1.2367% from 1.2377% the week prior. Oil recouped some recent loses, the US Dollar fell and Gold rallied. Market volatility remains muted, trading at 9.85, little changed from last week’s reading of 9.50.

US retail sales rebounded. After dipping 0.2% in August, US retail sales rebounded strongly in September, rising 1.6%. Higher gasoline prices in the wake of Hurricane Harvey and a jump in auto sales were major contributors, and are widely seen as temporary as Texas bounces back.

The latest US inflation read was flat – again. Despite the rebound in retail sales, the Fed’s favorite US inflation gauge – the Consumer Price Index (CPI) – missed estimates for the sixth time in seven months, even as a hurricane-driven spike in energy prices boosted the overall cost of living by the most since January. The higher gas prices contributed to a 0.5% advance in the CPI in September, but after stripping out the food and energy components, prices rose a muted 0.1% last month. Markets expected an overall pick up in price gains outside of energy in the aftermath of Hurricane Harvey – the data suggests that any broad acceleration in US inflation needs more time to gain traction.

Fed signaled December rate hike likely. Minutes from the September meeting of the US Federal Reserve’s Federal Open Market Committee showed that “many” members thought another rate hike was likely to be warranted late this year if the economic outlook remains roughly unchanged. However, some members expressed concerns that recent soft inflation data may not be temporary, as they’ve stated in the recent past. Falling prices for things such as mobile phone service and prescription drugs have temporarily suppressed inflation, according to the Fed.

IMF kicked off its fall meeting with a global growth upgrade. The fund’s growth forecast was slightly more upbeat, with global gross domestic product expected to expand 3.6% this year and 3.7% in 2018, a 0.1% increase from the last update in July. The IMF’s chief economist called the current global acceleration notable because it is more broad-based than at any time since the start of this decade. This year runs counter to many recent years when economists were forced to trim overly optimistic forecasts rather than raise them.

What to Watch This Week: After the data deluge last week, the coming week is a bit quieter with gauges on manufacturing, import prices, industrial production, home builder sentiment and several speeches from Fed officials, including Chair Yellen, taking the spotlight.

Markets will be especially focused on Fedspeak in the coming days as the most recent gauge of US inflation – the Consumer Price Index – registered yet another flat reading last month. Trends in both growth and unemployment suggest the opposite should be occurring. Treasury yields declined last week in response, implying that markets will be focused on the evolving theme intently as we approach what many believe – us included – that the Fed will hike in December.

Take-Away: So far this quarter, consumers, responsible for 75% of US economic activity, have exhibited a broad-based rise in sentiment across age, partisan affiliation and income. This rise has manifested in increased consumer-driven economic activity, specifically retail and durable goods purchases, suggesting that the strong labor market will continue to support economic growth despite the recent weather-relation disruptions. Most expect the trend to continue at least through the remainder of 2017.

The trillion-dollar question in markets now: As retail and durable goods purchases increase, where is the commensurate increase in inflation and will the Fed maintain its path of rate hikes if it doesn’t show up? Inflation is showing little evidence of re-accelerating toward the Fed’s 2% target range, as worsening deflation in the goods sector is offsetting a modest increase in price pressures in services. While market expectations have consistently placed the odds of a December Fed rate hike above 70% in recent weeks, we’re not totally convinced given the composition of voters on the FOMC at year-end, as several have expressed reservations about continuing to normalize policy without evidence that inflation is re-accelerating. As for the Fed’s recent proclamation that it expects to hike three times in 2018 and twice in 2019, they’ll likely walk back that path of hikes if inflation holds steady at its paltry 1.7% pace or falls further prior to December.

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