Low inflation is Federal Reserve’s flat tyre on road to recovery
The US Federal Reserve’s economic policy has a lot of moving parts, one of which is not performing as well as it should.
Inflation is the flat tyre on the Fed’s drive towards full recovery. Its refusal to rise is complicating economic policymakers’ lives. It appears that consumers are not spending the way they used to before the crisis, in spite of a more resilient jobs market.
Closer analysis reveals one strong underlying trend that kept inflation flat last month.
There are several reasons for the slowdown in the Consumer Price Index (CPI) but the main pressure is the fall in energy prices. Lower crude oil prices have plagued the oil markets. Energy prices fell by 2.7 per cent in the US, with a significant decrease of 6.7 per cent in the gasoline sector. The fall in energy prices trimmed price gains in other sectors.
As a result, the overall CPI in the US fell by 0.1 per cent last month, according to official figures. Where consumers gain with lower petrol prices, oil producers are losing with reduced income and profits. The GCC rift with Qatar has added considerable resistance to the oil price. Increased production in the US makes the barrel run over. The oil markets appear to be returning to their pre-Opec deal glut.
As long as the Qatar crisis threatens to derail the Opec supply-cut deal, traders are treading warily. Even the bulls are hanging back, refusing to charge.
Subsiding inflation didn’t stop the Federal Reserve from hiking its key interest rate 25 basis points to 1.25 per cent in June. But there’s only so long you can drive with a flat tyre.
At the time of writing, yields are falling, and the gold price is recovering as traders price in the new situation. Like inflation, yields are flattening, giving the Fed’s economic policy another challenge.
One of the risks of raising rates too fast, too soon is the possible negative impacts on yields, borrowing and spending.
Raising rates usually has a positive impact on yields and not the opposite. But what we are experiencing now is bond investors not believing the Fed can follow through with further rate increases this year.
In my opinion Janet Yellen and her team are trying to convince the markets that inflation is around the corner. By doing so the Fed encourages consumers to spend more and companies to invest and lend more. If this experiment works then it will have a positive impact on the economy, but the evidence isn’t convincing enough yet.
Was last month’s CPI just a one-off result, with inflation set to keep rising for the second half of the year? If so, it would be good news for the Fed, because normalising monetary policy would give it more tools in case another recession hits the economy.
Food and energy were the weak points, according to the Bureau of Labor Statistics.
If you take out the impact of energy prices on CPI, all other sectors show rising price trends. The index actually rose 0.1 per cent once food and energy were removed from the equation. This suggests that as long as energy prices stay subdued, US inflation is on a knife-edge.
As a safe-haven buy, gold rarely lies. Investors appear wary of the situation with US inflation. Bets are being hedged and the next economic indicators are sharply in focus.
This month’s NFP will need to be stronger than May’s 138,000 jobs added, which was lower than the expected 174,000 jobs.
Other than the headline NFP figure, investors are watching wage growth for signs of strength or weakness.
If there are more signs of a softening jobs market in addition to lower inflation, the Fed may moderate its hawkishness.
In that case, reduced expectations of more rate cuts might put pressure the dollar and support the gold price until the end of the year.
In that scenario, bond yields would also remain under pressure, and the hawks would face heavier headwinds.