Central Bankers – particularly the Fed and ECB – are faced with the problem of low inflation. It seems, traditional models of inflation forecasts are no longer working.
Consider this. After the financial crisis, the central bankers brought rates down and initiated unconventional policy methods like QE. In other words, they initiated a policy of easy money.
The economic situation of the developed countries has improved. The stock markets have seen triple digits growth while optimism continues to flourish. The United States has gone further by bringing down corporate and individual taxes.
As a result of easy money, credit card and the aggregate household debt are at an all-time high. At the same time, the debt default rate is also at a significant high.
Easy money, business and consumer confidence, improving manufacturing, and a 17-year low unemployment rate seems like a perfect combination of spurring inflation. Wrong. For several times, including in 2017, the Fed missed its inflation targets and we expect them to miss it this year.
Some expect the year to end with the inflation rate at around 1.7% below the Fed’s consensus rate of 2%. Others expect inflation to start going up fueled by the recently passed tax reform bill. What many experts will not tell you is how difficult it is to forecast inflation this year. This is because we are at interesting times with commodity prices soaring this year.
Some have attributed the low inflation rate to aggregate supply whereby, the supply of basic items has increased, mainly because of e-commerce. For example, Amazon, has become the biggest shopping destination in the country simply by slashing prices.
Tomorrow, we will receive Core Consumer Price Index (CPI) data from the Bureau of Labor Statistics. Traders expect the organization to release December’s Core CPI to improve by 0.4%.
In December’s reading, the food index remained unchanged with the food at home index declining by 0.1% (0.6% annually) while the index of the other food at home rose by 0.4%. The energy index increased by 3.9% fueled by the higher gasoline prices. In addition, the index for all items less food and energy increased by 0.1% in November after rising by 0.2% in October.
The numbers released tomorrow will provide an indication of how the Fed will move on this year. It comes a few weeks after Trump signed into law the new tax bill. However, we are unlikely to see major changes since people have not started to receive their tax cuts and companies have not yet started repatriating foreign cash.
In the December meeting, the FOMC accepted to raise interest rates. They also forecasted three more rate hikes this year. However, there was dissent with some members – like Kashkari – opposing rate hikes. According to Kashkari, rate hikes are not justified because of the low inflation rate. Traders will pay a close attention to tomorrow’s data because it might determine whether the Fed will raise rates in the January meeting.
However, I believe the Fed is not accounting for the potential risks. Yesterday, markets were rattled after reports from China indicated that the country would stop buying U.S debt. As a result, the Dow fell more than 100 points. The Fed did not expect such reports. However, it is highly unlikely that China will do that since it is the biggest holder of US debt.