June 13, 2017 / 5:10 AM / 2 months ago

Inflation fizzle may once again leave Fed rate path in doubt

FILE PHOTO: A police officer keeps watch in front of the U.S. Federal Reserve in Washington, DC, U.S. on October 12, 2016.Kevin Lamarque/File Photo

SAN FRANCISCO/WASHINGTON (Reuters) - The Federal Reserve will probably express its confidence inflation will climb towards its 2 percent target when it meets this week and delivers a widely expected rate rise, but such assurances are a poor indicator of the Fed's future policy.

The Fed, which last raised rates by 25 basis points at its March meeting, has penciled in three increases this year based on the view that inflation will eventually edge higher as a result of a tighter labor market that has driven the unemployment rate to a 16-year low.

Yet since March the Fed's preferred measure of underlying inflation has fallen to 1.5 percent year-on-year after touching 1.8 percent in February, even as unemployment rate has dropped to 4.3 percent of the workforce.

The central bank is likely to go ahead with another 25-basis-point rate increase on Wednesday, the fourth hike of a rate increase cycle that started in December 2015, citing the improvement in the economy and temporary factors driving down prices.

Fed officials have already noted a 9-percent drop in the cost of cellphone plans since February. Falling pharmaceuticals prices and slower rent increases have also mitigated inflationary pressures.

But the concern is the Fed and other central banks have been here before, consistently over-estimating inflation in the recovery from the 2008-2009 financial crisis and the pace at which interest rates would rise back towards pre-crisis levels.

"They are betting on the labor market tightness. They are still feeling that will eventually lead to higher wages, higher inflation,” said Omair Sharif, an economist at Societe Generale.

But that has been the Fed's bet for the past six or seven years, he said. "There's a real chance that if the inflation data doesn't cooperate the Fed is going to have to rethink."

The Fed has missed its inflation forecasts made at the end of 2012, 2013 and 2014. Those misses could be mostly attributed to forecasting errors over the price of oil and the value of the dollar, factors largely outside the Fed's control.

But now the 1.9 percent forecast for the end of this year, which Fed officials have maintained since December 2015 when they started raising rates from zero, also looks at risk.

WEAKENING CONVICTION

Investors are already taking notice.

A Reuters poll last week showed economists expect the central bank to follow its June move with another 25 basis point increase in the third quarter to take the fed funds rate to 1.25-1.50 percent.

But one in five said their conviction for that third 2017 rate hike was fading, and traders of short-term rate futures now see just one rate hike in 2018, down from two forecast earlier this year.

They are scaling back their expectations against the backdrop of inflationary pressures ebbing not just in the United States, but globally.

The European Central Bank last week cut its inflation forecasts and predicted weak prices for years to come.

The ECB has done no better than the Fed with its predictions and had said it expected to see inflation approaching 2 percent ever since it started making point forecasts in December 2013.

Other major central banks are also cutting their inflation forecasts. The Reserve Bank of India made substantial downward revisions last week and the Bank of Japan is expected to recalibrate its forecasts in July.

In China producer price inflation eased for a third successive month in May, the latest data available, suggesting a cool-down in the world's second-largest economy.

One factor that has repeatedly confounded policymakers was the behavior of incomes during the post-crisis recovery.

Even as the U.S. unemployment rate has almost halved in the past five years, earnings have barely ticked higher, with annual increases picking up to 2.5 percent from 2.1 percent. In 2007, the last time the unemployment rate was firmly below 5 percent, earnings were rising by 3.5 percent a year.

Fed Chair Janet Yellen has argued the Fed must act on its forecasts because changes in interest rate policy can take more than a year to impact the whole economy. She also notes that the central bank is moving slowly to remove monetary accommodation.

Carl Tannenbaum, Northwestern Trust's chief economist, said the Fed is not alone in its struggle to predict how prices will behave.

"If you would have told me that U.S. unemployment rate would be down to 4.3 percent and still have core inflation struggling to get above 1.5 percent, I would have been very, very surprised," Tannenbaum said.

For a grahic on inflation slowdown, click here

Reporting by Ann Saphir in San Francisco and Jason Lange in Washington; Editing by David Chance and Tomasz Janowski

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