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Fed Rate Hike Considerations: Are Inflation Pressures Building?

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May 24, 2016
Concern over stock market inflation increases as Federal Reserve discusses rate increase.

As expectations build for a Fed rate hike this summer, inflation remains a key consideration for the Fed. The latest Consumer Price Index (CPI) posted a headline surprise with a 0.4% month-over-month increase in April, stronger than consensus estimates. The CPI got a boost from energy prices, which were up 3.4%. Is this a warning shot on the inflation front? 

For those who remember double digit inflation of the late 1970's and early 1980’s, the recent levels of low inflation might seem pretty good. But, these days, the Federal Reserve (and other central banks around the world) are hunting for inflation, searching for any whiff that might signal a pick-up in growth. 

Simply put: some inflation is good, but a lot of inflation is bad. During the early 1980's, Federal Reserve Chair Paul Volcker took the federal funds rate to 20% in an effort to battle runaway price increases. A far cry from today. These days, a little inflation sprinkled into the economy could translate into higher wages, increased spending, and maybe stronger economic growth. 

"A small amount of inflationary pressures is not necessarily a bad thing. This is one of those times that people are hoping to see inflation," says JJ Kinahan chief market strategist at TD Ameritrade. 

Inflation Targeting: A Waiting Game?

The Federal Reserve juggles its dual mandate to promote maximum employment and stable prices with an inflation target of 2.0%. The Fed's preferred inflation gauge is the Personal Consumption Expenditure, or the PCE Index. Despite the recent uptick in inflation, economists at S&P Global don't expect the PCE to hit the Fed's 2% target in 2016. "The core personal consumption expenditure is expected to rise 1.5% on average year over year in 2016," says Satyam Panday, U.S. Economist at S&P Global. 

But the Fed may not wait until inflation hits the target to raise rates. 

More than actual inflation, it’s the expectation of inflation that’s more important to the Federal Reserve in its rate hike decisions, Panday says. "This is especially true now that it appears that they are close to bringing home the full employment mandate. The other mandate, inflation at 2%, still has some work to be done. We anticipate that the economic data out between now and the June 14-15 FOMC meeting will be favorable and prompt the Fed to raise the target federal funds rate by 25 basis points at its June meeting. Should the Fed pass on raising rates in June for an extra measure of confirmation on the data front, there's always July," Panday says. 

With or Without Energy?

Even as crude oil grinds toward $50 per barrel, concerns about the impact from rising energy prices are muted. "The price of energy is one of the greatest contributors to inflation. We can see a small amount of inflation if crude trades above the $50 level, but there is no significant inflation from energy until crude oil gets to $70 barrel," says Kinahan. 

Bottom line: don't expect runaway inflation anytime soon. In fact, risks still remain in the opposite direction. 

The Fed expects inflation to rise to a 2% annual pace in the medium term, but has time and again cautioned that it may take longer than anticipated, Panday says. "Wage inflation looks like it’s gently rising as of late, and that has given some confidence that inflation should gradually get to the 2% objective," Panday says. 

"We believe the risks to both economic growth and inflation outlook are little bit tilted to the downside due to uncertainties related to sluggish growth abroad and the wage-price spiral that may take longer time than anticipated," Panday says. 

For now, investors probably don't need to run for cover on the inflation front. Despite the unexpected pop in April CPI, inflation still may not even hit the Fed's target this year. But, the rising trend in inflation could give the Fed the confidence it needs to hike rates sooner rather than later. 

TD Ameritrade clients can monitor economic reports, including the CPI, gross domestic product, PCE, and employment report, which includes key average hourly earnings data, for more insight. See figure 1 below. 

FIGURE 1: MONITOR ECONOMIC INDICATORS.

To monitor economic indicators, follow the  calendar on thinkorswim. Log in to the platform and click MarketWatch > Calendar. Check the events box. Image source: the thinkorswim® platform by TD Ameritrade.  For illustrative purposes only. Past performance does not guarantee future results.

Dig deeper: Learn the ins and outs of the various inflation data and reports with a focus on one report the Fed monitors closely

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