HIGHLIGHTS OF THE WEEK
- Fedspeak took center stage this week. Fed Chair Yellen delivered prepared remarks to Congress, where among other things, she acknowledged the uncertainty as to when inflation would rise back toward its target.
- Taken together with Governor Brainard’s comments, markets interpreted the tone as dovish, with long-term Treasury yields and U.S. dollar falling, while U.S. equities soared toward all-time highs.
- Both the CPI and retail sales reports came in below consensus, adding further downside risk to the pace of Fed hikes over the next year and a half.
Soft Inflation Risks Delaying Fed Hike
Fedspeak took center stage this week with six members of the FOMC making public appearances. In what may be her last Congressional testimony as Fed Chair, Janet Yellen delivered prepared remarks and answered questions in both the House and Senate this week. She reiterated the Fed’s narrative that the economy is healthy enough to withstand further rate increases and that the process of balance sheet reduction is expected to begin this year. That said, she did acknowledge the uncertainty as to when inflation would rise back toward its target, noting that a handful of past factors would pressure inflation down until they drop out of the annual calculation. Inflation numbers out this morning confirmed that price pressures remained subdued in June, with the softness casting some doubt as to the idiosyncratic nature of the recent loss in momentum (Chart 1).
The Chair elaborated on the neutral rate of interest, noting that it is currently low, necessitating patience as far as rate hikes. However, she suggested that the neutral rate would likely move higher towards the 3% mark as the temporary factors holding it down ease off, motivating additional rate hikes over the coming years. This marked a divergence from Governor Brainard, who suggested in her remarks this week that the neutral rate is “likely to remain close to zero in real terms over the medium term.” Taken together, markets interpreted the comments as dovish, with long-term Treasury yields and U.S. dollar falling, while U.S. equities soared toward all-time highs. The latter were also buoyed by rising oil prices, on account of a bullish U.S. inventory report.
Yields and the dollar were further weighed down by a soft retail spending report with sales retreating in June, falling short of expectations for a modest gain (Chart 2). While the softer print leaves our second quarter consumption estimate still near 3%, the story is less upbeat as far as momentum heading into the third quarter with consumption on track to decelerate closer to the mid-2% mark. Together with the relatively broad-based weakness in discretionary spending categories, the poor spending performance leaves us somewhat puzzled – particularly given the continued strength in the labor market. On the whole, the combination of the weak CPI and retail sales reports adds some downside risk to the pace of Fed hikes over the rest of the next year and a half.
Still, we expect inflation pressures will begin to build through the remainder of the year, helped by an increasingly tight labor market. The labor market strength was reaffirmed by secondary data releases this week, with the JOLTS report indicating improved hiring and quit levels – the latter reflecting worker confidence – and upbeat worker compensation plans among small businesses in the NFIB survey. That said, the process of firming inflationary pressures is proving slower than expected.
Outside of the U.S., improving global growth appears to be emboldening other central banks to consider reducing stimulus. The Bank of Canada saw through soft inflation figures and raised its overnight lending rate this week for the first time in 7 years. Meanwhile, tightening talk has gained further traction at the Bank of England, and the European Central Bank looks to announce a taper schedule of its asset purchases later this year. Such convergence in monetary policy direction would help the Fed’s interest rate normalization plans, but for now all eyes remain firmly on inflation.
Admir Kolaj, Economist
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