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FOMC looks through lower inflation surprise

Financial Expertise

FOMC looks through lower inflation surprise

Latest US inflation data and the outcome of the FOMC meeting suggest that the US reflation story is intact, although in a less aggressive manifestation than implied by our previous projections.

The outcome of yesterday’s Federal Open Market Committee (FOMC) meeting was less of a surprise than the US inflation data for May released earlier in the day. As expected, the Fed raised the Fed funds target rate to 1%-1.25% and announced a plan to begin shrinking its balance sheet at some time “this year”. The Fed acknowledged the surprisingly low inflation reading, which revealed a slowdown of inflation from 2.2% to 1.9% for the headline rate and a decline from 1.9% to 1.7% for the core rate. Special factors, such as a fall in wireless phone service prices, have been made responsible for the lower inflation, which is an important sign that the Fed is prepared to look through the low inflation reading.

Although we agree with this assessment, our inflation forecast needs to be revised down and we revise this year’s projection to 2.0% and to 2.2% for next year, down from 2.6%. The new projection is now much closer to the consensus view. Lower inflation and the intention to start a balance-sheet reduction impact the future path of Fed funds. We shift the date for the next rate hike to December this year, allowing the Fed to start announcing its balance-sheet reduction in their September meeting.

For 2018, we forecast only two more rate hikes – in June and December – acknowledging our less aggressive inflation forecast. The upside pressure for 10-year Treasury yields is consequently much less pronounced than previously feared, and our year-end forecast is scaled back to 2.35%. The dollar should remain supported in the coming months despite this revision, as the pessimism regarding the US reflation story is currently much more widespread than our new projections imply.

We revise some of our forecasts and remain convinced that overcoming the current pessimism will result in some US dollar strength and higher bond yields in the next three to six months.

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