Global Daily – Fed hikes, but struggling with low inflation

by: Maritza Cabezas , Georgette Boele , Arjen van Dijkhuizen

Fed view: Forecasts: growth steady, inflation and unemployment lower – Fed officials raised the federal funds rate on Thursday by a quarter percentage point to a range between 1% and 1.25% and continue to forecast one more rate hike this year. In 2018 Fed officials continue to expect three rate hikes. This is still in line with our forecasts for the federal funds rate. As for the projections from the FOMC, compared to March, GDP growth forecast barely changed. Only 2017 GDP growth was adjusted slightly up to 2.2% compared to 2.1% projected in March. Meanwhile, unemployment and inflation were adjusted downwards, likely in response to the data of the past few months. Unemployment was lowered in 2017 to 4.3% from 4.5% forecasted in March, while unemployment will end now at 4.2% in 2019 compared to 4.5% previously forecasted. PCE inflation was lowered to 1.6% in 2017 from 1.9% forecasted in March. But forecasts for the following years were left unchanged and PCE inflation continues to move towards 2% in 2018.

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Inflation a topic of concern for the Fed- Lower than expected inflation has marked the cautious tone of the statement released after today’s FOMC meeting. This topic also dominated Chair Yellen’s press conference. Progress in meeting the 2% inflation target has slowed in the past months. However, Chair Yellen mentioned during the press conference that given the gradual improvement of the labour market, a gradual pace of rate hikes remains appropriate. She mentioned that one should not overreact to a few reports, and that inflation data could be noisy. At the same time, Chair Yellen mentioned that May’s inflation report was weak in a number of categories and that this was something to closely monitor. She also mentioned that there could be structural factors holding down inflation. The relationship between unemployment and inflation has weakened, but Chair Yellen insisted that it remained at work. This suggests that she expects further improvement in the labour market for inflation to pick up again. On top of this, we think that technological improvements are partly holding down inflation and this could continue going forward. This has been particularly the case of lower cellular phone service prices, which have put downward pressure on inflation in the past months.

Reducing the Fed’s balance sheet – The Fed released today an Addendum to Policy Normalisation, Principles and Plans, which spelled out in detail its strategy to reduce the Fed’s balance sheet.  The Fed intends to start reducing its holdings USD 6 billion in Treasury securities and USD 4 billion in mortgage bonds and to allow the amount to rise each quarter. These limits would ultimately rise to a maximum of USD 30 billion a month for Treasury and USD 20 billion a months for mortgage securities. This is a gradual and predictable plan. Although the timing of kickoff has not yet been announced, we expect that there will be little market reaction given its predictability. (Maritza Cabezas)

Global FX:  Fed saves US dollar for now – Earlier today the lower than expected US CPI and retail sales data sent the US dollar lower across the board. Financial markets were positioned for a somewhat dovish Fed. They were wrong-footed when the Fed sounded less dovish than expected with respect to its plans to continue hiking rates at a gradual pace. The US dollar made a U-turn. The US dollar index regained the lost ground of earlier today. After being close to 1.13 level before the Fed, EUR/USD fell to 1.12 again after the Fed decision. A similar price action was seen in the 2y US Treasury yield which first dropped and then recovered after the Fed decision. Gold prices gave up more than earlier gains, which is mainly a reflection of the loss in momentum. Going forward, the US dollar could recover temporarily if US data start surprising on the upside. If this is not the case and US economic data continue to disappoint going forward, it is likely that the US dollar will get under pressure again (Georgette Boele).

China Macro: May activity data point to gradual slowdown, no collapse – China’s monthly economic activity data published earlier today confirm that the Chinese economy has resumed a gradual slowdown, following Beijing’s targeted tightening measures aimed to prevent asset bubbles and to contain financial risk by reducing risky leveraged position taking and shadow banking and by cooling overall credit growth. Fixed investment slowed to 8.6% yoy (April: 8.9%), driven down by infrastructure and property investment. Meanwhile, retail sales (10.7% yoy) and industrial production (6.5% yoy) were flat compared to April. We should add that Chinese data for May were overall not that bad compared to the previous month and in some ways exceeded market expectations. This is also illustrated by Bloomberg’s monthly GDP estimate, which was stable in May compared to April at around 7,15%. All in all, we still believe that economic growth has peaked in Q1 and has resumed a gradual slowdown from Q2 onwards, but a growth collapse is not on the cards. See for more background our China Watch, Views from Shanghai, published today (Arjen van Dijkhuizen)