A green light for the Fed to raise rates

A narrow majority of the FOMC is likely to vote to raise rates this week after the core CPI pointed to high ongoing inflation amid upside risks to inflation from the Iran war and no slack in the labour market. Further hikes seem likely and policy rules have long pointed to a peak in the funds rate of about 4½%.

• The core CPI has likely pushed most FOMC members over the line for raising rates this week.
  The final piece of data has fallen into place for a narrow majority of the members of the FOMC to vote to raise rates when it meets on 15-16 September. The latest CPI points to the core PCE deflator – which is the Fed’s preferred measure of inflation – picking up from 0.2% in July to 0.3% in August when it is published later this month. The Fed wouldn’t normally react to one month’s data, but this represents an accumulation of evidence that core inflation is likely to remain above target for longer than the FOMC had expected, while the Iran war has refreshed the upside risks to global inflation, the AI boom is already boosting consumer prices, and there is no apparent slack in the labour market. The concern about high inflation is unlikely to be assuaged by an expected slight downward revision to inflation over recent years when the BEA tries to better measure the prices of some tech goods and professional services as part of its five-yearly overhaul of GDP at the end of this month.

• While overshadowed by surging fuel costs, a rate hike ahead of the mid-term elections would be politically awkward for the Fed.
  Fed Chair Warsh – who reportedly speaks regularly with President Trump – would presumably prefer to delay a decision on raising rates until after the mid-term elections in early November, although he seemed to see the writing on the wall when he recently said, “We must be confident that underlying inflation is moving to our [2%] objective, clearly and at sufficient speed. Otherwise, we have work to do”. A rate rise would be politically damaging for the government, although polling and market odds – while not always reliable – have pointed to the Republicans losing control of the House for some time, underscored by the latest surge in energy prices. If that happens, fiscal policy will likely be set on autopilot, with the Federal budget deficit currently around 7-8% of GDP and net interest payments accounting for about half of that shortfall.

• More rate hikes still seem likely.
  Looking past September, further rate rises seem likely as policy rules have long pointed to a peak in the funds rate of about 4½% given above-target inflation and the absence of slack in the labour market. However, there is some risk of a higher peak in the funds rate if the neutral policy rate – which can only be inferred – has sustainably increased further over the past couple of years. The median FOMC estimate of the neutral rate is about 3%, although averages based on academic/Fed models and market pricing are higher at about 3½% and 4%, respectively. The current sell-off in global bond markets reinforces this risk because it has been partly driven by expectations of higher average interest rates over coming years on the back of increased demand for credit from a heavily indebted US government and a rapidly expanding tech sector.

• The Iran war poses a key risk to the outlook, while the market will find it harder to read the Fed if Warsh succeeds in stopping the Fed from being open in explaining its views and actions.
  A key risk to the outlook relates to the Iran war, where high and volatile energy prices pose a downside risk to activity and an upside risk to inflation, particularly if high prices finally force medium- and long-term inflation expectations higher. The latest round of attacks, which has involved the Houthis, might ease once the mid-term elections are out of the way, but it is unclear what will happen.
  Another risk relates to Fed communication, where Fed Chair Warsh shows a deep admiration for the Greenspan-style approach of telling the market next to nothing. Warsh wants the FOMC to meet less often and provide the market with much less information, including stopping the publication of unattributed policymaker forecasts. If he succeeds, market pricing will be more volatile and investors will be back in the era of having to weigh up different private and public comments from Fed governors and presidents.

In terms of the CPI:

• The core CPI rose by 0.3% in August after a 0.2% increase in July. This was the largest rise since April and comes after the core CPI was unchanged in June. Annual inflation edged down from 2.5% to 2.4%. The trimmed mean CPI rose by another 0.2% in August to be 2.6% higher than a year ago.

• Core goods prices rose by 0.1% in August after rising by 0.2% in July. The impact of tariffs is fading, but there is upward pressure from rising tech prices and global supply disruptions stemming from the Iran war. Core services prices rose by 0.3% after increasing by 0.2% in July (another 0.4% rise excluding housing), to be 3.0% higher than a year ago (the same excluding housing).