Atlanta Fed President Dennis Lockhart says that the central bank is still on track to start raising interest rates in mid-2015. Speaking at a conference yesterday, he reasoned that the U.S. economy “is hitting on all cylinders.” But the renewed decline in bond yields, driven by an accelerating wave of disinflationary momentum around the world, suggests that the first rate hike will be delayed.
Earlier today Britain reported that consumer inflation slumped to just 0.5% on a year-over-year basis in December—half November’s rate in the UK. Meanwhile, eurozone inflation dipped into negative territory in December for the first time in five years. Pricing pressure in the US is stronger, but December’s update on consumer inflation due on Friday is expected to show some deceleration as well.
Quite a lot of the disinflationary wave of late is due to tumbling energy prices. The US benchmark—West Texas Intermediate—is trading below $45 today, a 5-1/2-year low. “Prices continue to free-fall and there is little that can stop them,” advises Amrita Sen, chief analyst at Energy Aspects, in a report via Bloomberg.
Disinflation looks quite a bit milder if nonexistent when measuring prices on an ex-food-and-energy basis–so-called core inflation. Nonetheless, it’s getting harder to imagine that the Fed will start raising interest rates while inflation remains well below its 2% target. The Fed’s preferred measure of inflation—the Personal Consumption Expenditure (PCE) Price Index—ticked down to a 1.2% annual rate in November vs. 1.4% in the previous month. Core PCE was modestly higher at 1.4% in November, but here too the core rate slipped from an annual 1.5% pace in the previous month.
The Treasury market’s implied inflation forecast anticipates even lesser levels of inflation. Indeed, downside momentum prevails in the yield spreads between nominal and inflation-indexed Treasuries (5- and 10-year maturities). The 10-year spread, for instance, implies an inflation rate of just 1.57% as of yesterday (Jan. 12)—the lowest since August 2010.
Nonetheless, the New York Fed reports that consumer expectations of future inflation are holding steady. The bank’s December 2014 Survey of Consumer Expectations reports that the median consumer inflation expectation was unchanged at around 3.0% vs. the previous month. But market sentiment suggests otherwise. The Wall Street Journal notes that “a wave of global economic gloom has turned the U.S. money market on its head, with more investors now betting that the Federal Reserve will be forced to delay raising interest rates.”
Based on the US economic trend, the case for raising rates at some point in the near future still looks compelling. Employment growth is picking up and consumer spending and income increases look encouraging too. But if a stronger economy has traditionally been seen as a reason to sell bonds (and thereby raise yields), the precedent is breaking down these days. Notably, the yield on the 2-year Treasury—widely considered to be the more sensitive maturity for monitoring rate expectations—has tumbled sharply in recent sessions. That’s a sign that the crowd is betting the Fed’s first rate hike will arrive later than previously expected.
Even the improvement in the labor market in recent months leaves room for doubt about the timing of the Fed’s first rate hike. As University of Oregon economist Tim Duy writes at his Fed Watch blog, “the December employment report, with its surprising combination of solid job gains and decelerating wage growth, leaves Fed policy up the air.”