Inflation Front and Center of Fed's Rate Hike Strategy

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No economic indicator will be more closely watched throughout 2016 than inflation. It will determine how much you pay for a house or a car, how much you earn on your savings account and how the stocks perform in your 401k.

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In other words, inflation is at the center of the economic universe because it will determine the trajectory of interest rates. And interest rates, because they establish the costs for borrowing and lending money, determine an array of important consumer spending and saving habits.

No one will be watching inflation closer than Federal Reserve policy makers, who are charged with setting interest rates. The Fed would like to lift interest rates back to a level between 4%-5%, one seen ahead of the 2008 financial crisis. But weak inflation is holding them back.

The Fed had hoped to raise rates as much as four times in 2016, to about 1.25%, basing that hypothetical upward trajectory on a strengthening U.S. jobs market that would lift wages and ultimately consumer prices, ie., inflation.

For the most part, the U.S. has cooperated with this plan. The rest of the world, not so much. Given recent concerns for global growth, most economists now believe the Fed will raise rates once -- or at most twice -- more in 2016.

A rate increase at the Fed’s March 15-16 meeting, once a virtual certainty, is now highly unlikely.

“The U.S. economy is stable, not great but stable. The world economy is one problem after another,” said Cliff Waldman, senior economist for the Manufacturers Alliance for Productivity and Innovation (MAPI), a public policy and economics research organization in Arlington, Va. “For inflation to rise in the U.S. what has to happen is very simple -- the global economy has to at least stabilize.”

A stabilized global economy would go a long way toward lifting wages in the U.S., according to Waldman. Stronger economies, particularly in Europe and China, would gin up demand for U.S. goods, creating jobs that would help lift wages.

Stronger global economies could also lower the value of the U.S. dollar as it would prompt investors to spread their money around among a slew of healthy currencies. Instead, investors have been ploughing money into the dollar, pushing its valuation higher. A strong U.S. dollar makes U.S. exports more expensive, a situation that has hammered domestic manufacturers in recent months.

“If we had a weaker dollar, they’d be buying our stuff. But they’re not,” said Waldman. “The strong dollar is making a weak demand for our goods situation all the more worse.”

Ideally, the U.S. economy would be humming along with inflation hovering at about a 2% annual growth rate. That 2% growth rate is viewed as healthy by economists because it means prices are rising modestly as wages move higher. And the reason wages move higher is because there are lots of jobs available and employers have to pay more for the most qualified workers. But despite strong monthly job creation and the unemployment rate falling to 4.9% in January, a seven-and-a-half year low, wages for U.S. workers haven’t risen accordingly.

A little bit of inflation is good, but a lot of inflation – so-called runaway inflation – is bad. That’s when prices are rising so quickly – much faster than wages -- that consumers’ paychecks become stretched way too thin.

What’s arguably worse than runaway inflation is deflation. That’s when prices slip into freefall because of lack of consumer demand and it’s extremely difficult to break out of because consumers get caught in a mindset of falling prices and cut back on their spending, hoping prices will fall further.

Inflation watchers got a modest boost last week with the release of a key measure of core consumer prices, or those that exclude the volatile food and energy categories. The CPI index rose 2.3% year-over-year in January, lending support to the Fed’s longstanding prediction that inflation will gradually rise toward the central bank’s 2% target.

“Friday’s CPI report should have raised the Fed’s confidence that inflation is gradually trending back to 2%,” said PineBridge Investments Chief Economist Markus Schomer.

Schomer said inflation is at the center of the Fed’s long-term rate hike strategy.

“The way I see it, inflation is the reason the Fed has adopted a tightening bias, but it doesn’t drive the meeting-to-meeting decision whether to raise or not. That decision is driven by data, market volatility and the extent to which rate hikes are priced in,” he said.