Is the Fed Wrong Again on Interest Rate Hikes and Inflation?

Is the Fed Wrong Again on Interest Rate Hikes and Inflation?

Even before the Federal Reserve officially ended its QE3 bond-purchase program, investor attention shifted to the timing and pace of the Fed's eventual short-term interest rate hikes. The Fed's policy statement last week was surprisingly confident, downplaying recent declines in the inflation rate and an ongoing lack of wage growth in the job market.

This is a big deal, since the Fed hasn't raised interest rates since 2006 and hasn't started a tightening campaign since 2004.

Right now, the consensus puts the first hike sometime in the middle of 2015 and has the Fed's policy rate at around 1 percent in the summer of 2016, up from just above zero now. But the Fed's own forecasts are much more optimistic than the bond market, with policymakers looking for the rate to stand at around 1 percent next summer and 2.5 percent by the summer of 2016.

Some on Wall Street are even more cautious, with Goldman Sachs, for example, not looking for the Fed to hike rates until next September.

So, who's right?

The problem is that inflation is below the Fed's 2 percent target and moving in the wrong direction in recent months. The recent drop in crude oil from a peak of nearly $108 a barrel in June to recent lows below $80 has played a role, as has the recent stalling in the housing market and the cooling of once red-hot areas of inflation, like health care costs.

Related: Alan Greenspan, Former Fed Chair, Goes for the Gold

The Fed has a history of overestimating inflation's rise:

In April 2010, Fed officials were looking for inflation in 2012 of 1.2-2.0 percent.

In April 2011, they were looking for inflation in 2013 of 1.4-2.0 percent.

In April 2012, they were looking for inflation in 2014 of 1.7-2.0 percent.

In March 2013, they were looking for inflation in 2015 of 1.7-2.0 percent.

And in September 2014, they were looking for inflation in 2016 of 1.7-2.0 percent.

And yet their preferred measure of inflation, the Personal Consumption Expenditures Price Index or PCE, hasn't been above 2.0 percent since 2012 and hasn't been a concern since 2011.

What's notable is that this stalling of inflation came within the context of the entire QE3 program — a program that was intended, when announced in September 2012, to help ensure that inflation recovered to the Fed's target level (too low inflation carries risks of a Japan-style debt-deflation trap).

So on that measure, QE3 was a failure. When they pulled the plug on QE3 at its October policy meeting, Fed officials talked up the fact that survey-based measures of inflation expectations (rather than direct market-based measures) remain stable and that the risk of inflation remaining too low had "diminished somewhat" from earlier in the year.

The timing of the Fed’s rate hikes is predicated on policymakers’ belief that inflation will be driven by the tightening of the labor market, with the unemployment down to 5.9 percent and the job openings rate at its best level since the dotcom bubble. Yet the bond market doesn't share this optimism.

Economists at Goldman Sachs believe that, should inflation remain below target, the Fed will be forced to acknowledge reality and revise its rate hike timing. This, the Goldman team says, could significantly delay the end of the Fed's 0 percent interest rate policy.

Related: Something Is Dangerously Wrong at the New York Fed

The dollar's recent strength, especially against the Japanese yen, is expected to exacerbate the problem by lowering the cost of imports and trimming export activity. In the minutes of their September policy meeting, "a couple" Fed officials expressed concern that the dollar's rise would jeopardize the gradual increase in inflation to their target. It'll be interesting to see if this concern becomes more widespread when the October meeting minutes are released in November.

The other problem is the ongoing weakness of industrial commodities, particularly crude oil, driven by the combination of a lack of production cuts from OPEC members (especially Saudi Arabia) combined with economic weakness in Europe and Asia.

As a result of all this, Goldman estimates inflation will be below both the Fed's estimates and current market-implied estimates as well. That means that not only does the Fed need to lower its forecasts to match where the bond market is, but the bond market is probably still being too optimistic on the pace and timing of rate hikes.

This means that short-term rates could stay near zero into 2016.

Related: Are 401(k) Plans Setting Up Millennials for Pain?

It also means that the situation isn't likely to change until the dollar weakens significantly or crude oil rises or wages jump or higher rental costs boost inflation. Like so much in life, this could just be a matter of being patient and giving the economy time to complete its healing process. The tightening underway in the labor market, with businesses reporting a tougher time finding qualified applicants, is a sign this process is ongoing.

For investors, it means that the liquidity-fueled rise in stocks could last much longer than many realize.

Bank stocks, particularly regional banks, could be the big winners in all this, as low short-term rates combined with higher long-term interest rates (as inflation increases) will boost net interest margins. As a result, I recommended the Regional Banking Index ETF (KRE) to my Edge newsletter subscribers on October 21.

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