Are We There Yet? Yes, Now What Happens?

For years we have been in the world of the “new normal” where ultra-accommodative central bank policies (near zero interest rates, quantitative easing through massive bond purchases, etc.) result in little or no inflation. These metrics would be considered unthinkable in the pre-2008 era, when inflation was a constant and a real threat. During the last few years, the Fed has made it clear that their targets for full employment and normalized price increases were “2 and 4” (2.0% inflation and 4.0% unemployment). So Monday’s report indicating that the Fed’s preferred inflation gage, Personal Consumption Index (PCE), rose 2.0% for the year. Also, this is not an anomaly; the classic elements of a true inflationary environment are in place. Oil prices are firming up and the employment cost index rose 2.7% for the last year (and 0.8% in the first quarter alone). However, first quarter GDP cooled to 2.3% after hovering around 3.0% previously (this may be seasonal as consumers often cool off in the early part of the year). Today’s Fed meeting statement confirmed that inflation should “run near” 2.0% (this is an update from the March statement indicating that inflation would “move up” to 2.0%). The new fascinating term in the statement is “symmetric inflation”, this is being interpreted as a signal that the Fed won’t overreact to inflation at 2.0% and may tolerate a number slightly above that after so many years below. So two more hikes this year and possibly three are a certainty barring some unforeseen market issues. Keeping to the schedule of rate increases, it looks like June and September are the likely dates, with December as a “wild card” potential 4th increase in 2018. Note that the most influential Fed officials have targeted a “neutral rate” of 2.50% (a couple years ago the target neutral rate was 3.25-3.50%, the lower rate indicates officials believe a long period of “secular” low interest rates is appropriate). Last week’s dovish ECB statement putting off the end of their quantitative easing helped lower the 10 year T to 2.96% as 3.02% remains the recent peak (again). Always remember that the Fed controls a short term rate, long term rates are products of supply/demand dynamics and expectations for future inflation and growth. Stay tuned.  By David R. Pascale, Jr. , Senior Vice President at George Smith Partners