- The Federal Reserve's favorite inflation gauge rose to 2 percent in May, matching the central bank's target.
- That on its face would give a green light to the central bank to continue its slow, steady rate-hiking plan.
- However, the bond market has been reflecting fears that a recession could be on the horizon, an obvious obstacle to the Fed's intentions.
For 10 years, the Federal Reserve has stalked its prey — inflation — but has mostly come up empty. Now that it has caught up to its goal, the question is what will happen next, and the answer isn't obvious.
Core personal consumption expenditures, the central bank's preferred inflation gauge, rose to 2 percent in May, matching the Fed's long-run target. That's the first time that has happened since a five-month period that ended in April 2012, and marks a possible milestone in the effort to normalize policy from its extreme crisis-era accommodation.
On the surface, the climb to 2 percent would indicate a clear path for the policymaking Federal Open Market Committee to continue on its trajectory of slow, steady rate hikes. However, the calculus will remain difficult for officials as they seek to divine whether the economy is on the cusp of breaking out, or on the road to recession.
"They're going to likely continue to raise rates and lower the balance sheet," said Joe LaVorgna, chief economist for the Americas at Natixis. "That seems to be their M.O., which is a mistake."
FOMC members indicated at their meeting earlier in June that they were likely to increase rates twice more in 2018 — in September and December — and three more times in 2019. That comes amid an operation to shrink the size of the bond portfolio the Fed keeps on its $4.4 trillion balance sheet.
LaVorgna favors the balance sheet reduction but thinks the Fed should slow down on the rate increases. Markets have been restless with the ramped-up schedule of rate hikes.
The has fallen 4 percent since the June 12-13 FOMC meeting. At the same time, the benchmark 10-year Treasury yield has fallen from near 3 percent to about 2.84 percent, while the two-year yield has edged higher to 2.53 percent, sparking worries that the two might invert and trigger what has been a classic recession signal.
"If the Fed goes two more times this year ... the yield curve inverts, certainly by early Q4," LaVorgna said. "If that's the case, you want to be on the lookout for recession as early as Q4 of 2019" as there is typically a lag time of five quarters from when the curve inverts to when an actual recession takes hold.
The threat of the Fed tightening the economy into contraction could be at the root of why the market doesn't quite believe that the central bank will be as aggressive as it is indicating.
Despite an upward shift in the "dot plot" of individual committee members' expectations for rates and Chairman Jerome Powell's explicit statements that further rate hikes are warranted, the market is only pricing in one more increase this year.
The fed funds futures market, where traders make bets on the central bank's benchmark rate, is indicating just a 45 percent chance of a December increase, according to the CME's FedWatch tracking tool. In fact, the indicator is showing a 10 percent chance of a rate cut at the meeting that would negate the September increase. The Fed has hiked rates twice this year, most recently at the June meeting, and the current target is at 1.75 percent to 2 percent.
Even with inflation at 2 percent, "monetary policymakers cannot rest easy," Gus Faucher, PNC chief economist, said in a note. "Inflation was briefly at the goal about five years ago, but then moved stubbornly below it."
The Fed believes 2 percent inflation is a level at which the economy is running at a sustainable growth rate.
But the Fed has struggled over the past six years to meet its prices goal even as employment — the other part of the Fed's statutory dual mandate — has surged. The unemployment rate is now at 3.8 percent, tied for the lowest since late 1969.
Lack of wage pressures has stymied economists at the Fed and on Wall Street, though many predict that a tighter labor market eventually will push pay higher and justify the Fed's intentions.
"The Fed is projecting that core inflation will not rise further from here, but we suspect that core inflation will continue to trend higher, as capacity constraints begin to bite," said Michael Pearce, senior U.S. economist at Capital Economics. "That will keep the pressure on the Fed to keep hiking rates once a quarter over the coming year or so."
The pace of economic growth, though, remains an open question.
While the Trump administration has been touting potential GDP gains of 3 percent or more, the first quarter of 2018 came in at just 2 percent, and the Atlanta Fed on Friday slashed its second-quarter projection to 3.8 percent from 4.5 percent.
Mohamed El-Erian, chief economic advisor at Allianz, said the Fed won't be able to meet its aggressive forecasts, but still will be able to keep raising rates.
"People are comfortable with the notion that the U.S. will outpace other countries, that U.S. growth is solid, that the major risk for U.S. growth is external and not internal and that the Fed will continue with its 'beautiful normalization,'" El-Erian told CNBC's "Squawk Box," using a term he has coined for the central bank's process. "I think we get three, not four, rate hikes this year, and I think the Fed is on a good course."