Despite rising inflation, the Fed doesn’t waver

Macro Highlights - 23/02/2017

Inflation in the United States is on the upswing, fuelled by the year-over-year rise in oil prices, but this should only be temporary. Core inflation should thus not be affected by second-round effects. Janet Yellen gave a hawkish speech in which she reiterated the Fed’s intention to raise rates, yet she did not sound the alarm. We still expect the next fed funds rate hike to be a 25bp increase in June 2017.

In the United States, inflation reached 2.5% in January 2017, its highest level in five years. It comes as no surprise that this price rise was driven mainly by the strong year-over-year jump in energy prices, which added 0.9% to the inflation figure. Apart from a slight increase in transportation prices, inflation in other sectors remained stable year over year. Therefore, core inflation, which excludes food and energy prices, rose by only 0.1%. This slight rise in January was expected, and core inflation should now continue to fluctuate between 2.1% and 2.3% in 2017, for two main reasons.





  1. At this point, we do not expect any second-round effects – i.e. the knock-on effects that a rise in overall inflation can have on wages and non-energy products. This price movement should only be temporary, since we expect oil prices to remain stable. Inflation should again rise sharply in February before returning quickly to around 2%. If inflation falls quickly, as we expect, there should be no second-round effects and no upward pressure on core inflation.
  2. Import prices should apply downward pressure on core inflation. A look at the import price index shows that the price of petroleum products increased, while the price of non-petroleum imports declined, as expected, following the rise in the dollar (see right-hand chart above). As core inflation does not take energy prices into account, it will be affected by the slight dip in the price of other imports. Overall, core inflation should remain in line with our forecast of a moderate increase in GDP growth, which should reach 2% in 2017.

During her semi-annual report to Congress, Janet Yellen’s tone was firm, but she did not give the impression that the US Federal Reserve was either worried about or surprised by the recent inflation trend. The Fed chair reaffirmed the Fed’s view that it would be unwise to wait too long before raising the fed funds rate and added that the Federal Open Market Committee (FOMC) would consider, in its “upcoming meetings”, whether it was time to raise rates – yet she reiterated that monetary tightening would be gradual.

Yellen was also more specific on the Fed’s intention to reduce the size of its balance sheet. In recent weeks, several members of the FOMC have indicated that, if necessary, the Fed could tighten monetary conditions by simply not reinvesting proceeds from maturing bonds that the Fed had bought as part of its quantitative easing programmes (this would gradually deflate the Fed’s balance sheet, which has remained unchanged at close to USD 4.5 trillion since the end of 2014). Yellen confirmed that, over the coming months, the Fed would discuss reducing its balance sheet. But she also reiterated that such a move would only take place when the Fed’s rate hike cycle was “well under way”, adding that the FOMC did not intend to use its balance sheet as a monetary policy tool.

 Analysis and implications:

  • The tone of Yellen’s speech was hawkish, as she confirmed the Fed’s intention to raise rates, yet she did not sound the alarm. In stating that the FOMC would discuss whether or not to raise the fed funds rate at its “upcoming meetings”, the Fed chair left the door open to a potential rate hike at its 15 March meeting. We continue to believe that the dollar's rise and the uptick in bond yields in the second half of 2016 will weigh on GDP growth in the United States in the first half of 2017. As a result, we still do not expect the next 25bp increase in the fed funds rate to take place before June of this year.
  • The issue of whether to reduce the size of the Fed’s balance sheet could become a recurring topic in monetary policy discussions over the next few months. Our view is that the Fed will be in no hurry to stop reinvesting the proceeds from maturing bonds, in order to avoid putting undue upward pressure on long-term yields. We still believe that the Fed will stop these reinvestments in the second half of 2018.

In China, new loans issued in January reached CNY 2.030 trillion, significantly higher than the amounts seen in preceding months. This helps to explain the monetary authorities’ more restrictive tone. This shift is also motivated by the sharp increase in aggregate financing, which includes some shadow financing. Inflation rose to 2.5% in January, driven mainly by an increase in food, energy and transport prices. In the medium term, we expect inflation to level off: a deceleration in economic activity and slowing wage growth suggest average inflation of 2.3% in 2017.