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Net Net: Promoting innovation and managing change

Fed may have just gotten a red light for rate hike

Inside the mind of the Fed

The Federal Reserve got a little more breathing room Wednesday from the push to raise interest rates in September.

A widely followed inflation gauge—though not the Fed's favorite one—showed that outside of rising rents, there was little price pressure in the marketplace. The consumer price index rose just 0.1 percent in July. Even excluding food and energy prices, the CPI was only up the same 0.1 percent.

On an annualized basis, the index rose just 1.8 percent, which is below the Fed's current 2 percent inflation target.

Tumbling energy prices are the root of the CPI's weak performance, with the overall sector down 14.8 percent over the 12-month period, though up 0.1 percent for the month. One of the the more notable increases came from rent, which rose 0.3 percent in July and 3.6 percent for the year. Airfares plunged 5.6 percent, the most in 20 years, and fuel oil fell 3.4 percent in July.

Viewed together, the data take still more of the steam out of an argument for the Fed to raise rates in September for the first time in more than nine years.

Janet Yellen
Kevin Lamarque | Reuters

"A weaker-than-expected rise in consumer prices at the start of Q3 further fuels the dovish argument for the Fed to remain on the sideline, delaying liftoff beyond the September FOMC meeting," Lindsey Piegza, chief economist at Stifel Fixed Income, said in a note. "Since the end of 2012, every Fed communication has continued to acknowledge the substandard level of inflation which continues to persist. Thus, at this point, raising rates with inflation so far below the Fed's target could create a misperception in the marketplace that the Fed has lowered their inflation goal."

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Investors will get a closer look at Fed thinking Wednesday at 2 p.m. when the Fed Open Market Committee releases the minutes from its July meeting.

The committee initially had targeted a 6.5 percent unemployment rate and 2.5 percent inflation before tightening policy, but both numbers have become moving targets amid uneven economic growth. Though the headline jobless figure, excluding those not actively looking for work and the underemployed, has fallen to 5.3 percent, the Fed remains handcuffed by the weak inflation readings.

Its preferred gauge for that metric, the personal consumption expenditures price index, shows even a lower level of inflation than the CPI. The core PCE's latest reading, in June, was just 1.3 percent. While consumers might scoff at an inflation gauge that omits food and energy, Fed Chair Janet Yellen generally dismisses price fluctuations in both categories as "transitory" and therefore not central to monetary policy decision-making.

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Low inflation readings, particularly the latest CPI, "will certainly give the Fed pause for thought in whether to raise interest rates or not at the next FOMC meeting in mid-September," Paul Ashworth, chief U.S. economist at Capital Economics, said in a note.

"On balance, we still think the Fed will go ahead and raise rates in response to the cumulative improvement in labor market conditions. But the decision is finely balanced," Ashworth added. "With underlying price inflation and wage growth still muted, a case can also be made for waiting."

Anecdotally, most Wall Street economists seem to expect a September hike. However, traders at the CME are less convinced, with futures trading indicating a 45 percent chance of an increase at the meeting. A month ago, though, the probability was just 26 percent.