Why the Fed remains on a gradual tightening path

Thought of the day

by Chief Investment Office 12 Apr 2018

Political risk continues to dominate the headlines, although the focus for now has shifted away from trade rhetoric toward the worsening situation in Syria, and the potential for US military action.

While political tail risks are weighing on sentiment toward risk assets – the S&P 500 fell 0.55% yesterday – concerns that higher inflation could prompt a faster pace of tightening by the Federal Reserve have abated.

  • The recent rise in inflation is not a cause for concern. The increase in annual core CPI – to a 13-month high of 2.1% in March from 1.8% in February – stemmed largely from last year's plunge in prices for mobile phone services dropping out of the calculation. The minutes from the Fed's March meeting, released yesterday, also confirm that officials expect inflation to move higher.
  • The Fed has also made clear that its 2% inflation target is not a hard ceiling, and that a modest overshoot in inflation toward 2.2–2.3% would not constitute overheating that would require a change in the pace of tightening.
  • The minutes noted that retaliatory trade action by other countries was a downside risk. While not our base case, trade frictions that escalated and became economically disruptive might prompt the Fed to pause its tightening, not accelerate its pace.

In our view, the Fed remains firmly on track to raise rates once per quarter. At this point, the risk of faster hikes appears to be low. Even if core PCE inflation, the Fed's preferred measure, hit the 2%-target in March, the market is unlikely to shift beyond a consensus of once-per-quarter hikes. We remain overweight 10-year US Treasuries.

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