Fed – Fed Faces Inflation Conundrum

The Federal Reserve is currently facing a dilemma as the two sets of economic indicators they most closely monitor are sending conflicting signals about the urgency of additional rate increases.

The unemployment rate, which hit a 16-year low in May, shows labor markets are tightening. That argues for the Fed to keep lifting interest rates to prevent the economy from overheating. But inflation is drifting away from the central bank’s 2% target, suggesting borrowing costs should stay low to strengthen price pressures. Moreover, the recent inflation weakness appears more broadly based than it did when officials met last month.

After touching the Fed’s 2% annual target earlier this year, inflation has been weak for three consecutive months according to the Fed’s preferred gauge. Top Fed officials have recently questioned, but not scrapped, their expectation that the inflation weakness will prove transitory as projections forecast that inflation will return to the 2% target by the end of 2018.

The inflation weakness hasn’t moved the Fed off this course yet, but it could be harder for Ms. Yellen to maintain agreement now that the unemployment and price data are pointing interest-rate policy in different directions. This softness has given more ammunition to the Fed’s so-called doves who want to see more proof of price pressures before raising rates. Inflation has remained below that target almost continuously for more than eight years, including virtually the entire 5½-year period since the Fed formally adopted the target.

The stock market has gone more than a year without a 5% pullback, but a correction isn’t the only thing missing in action. What’s also baffling is the mystery of disappearing inflation. A correction, like your misplaced car keys, will turn up sooner or later. But inflation’s absence has become especially glaring after the long, loud drum roll anticipating its appearance—what with our economic expansion entering its ninth year, a well-publicized synchronized global recovery, the Trump administration’s promise of fiscal stimulus, and tightening policies by central banks from the U.S. to China.

Yet the core Consumer Price Index eked out a year-over-year increase of just 1.7% in June, the slowest in two years. Stripping out shelter costs, core inflation grew just 0.6%, the most sluggish rate since 2004. Personal-consumption expenditures are growing at a 1.4% pace, shy of the Federal Reserve’s 2% target.

The Goldilocks Scenario

Low inflation, slow-but-positive global economic growth, increasing stock earnings and accommodating central banks have allowed the markets to enter the Goldilocks zone.   We think these conditions can last for the next 6 to 12 months but a minor misstep could roil the markets.  This is not the time to become complacent but rather increase your awareness because a market correction is overdue.  Equity markets are not cheap and could become significantly overvalued if earnings do not improve to keep pace with prices.

Please contact your Shamrock Relationship Manager to schedule a call to discuss our outlook for the markets and how your portfolio is positioned to participate as asset prices increase and protect during the next correction.