Now that Fed Chair Janet Yellen has spoken, the market is more anxious than ever about this week’s inflation data.
Federal Reserve officials have recently been saying the dip in inflation is probably transitory. Yellen, however, raised a red flag on inflation, both in prepared remarks and also during testimony before Congress on Wednesday.
“She took a very small step acknowledging it might not just be transitory factors. They’re watching it carefully,” said John Briggs, head of strategy at NatWest Markets.
This week’s data releases include PPI, or producer level inflation, on Thursday, but the report markets care most about is the CPI, or consumer price index, which comes out on Friday morning.
Yellen testifies again Thursday, before the Senate Banking Committee, and the markets will be listening for consistency on her inflation remarks as well as any clarity on interest rates or clues on when the Fed might start taking action to shrink its balance sheet. Yellen’s prepared remarks noted the Fed is cautious about inflation, and she repeated it at the hearing.
“Temporary factors appear to be at work. It’s premature to reach the judgment that we’re not on the path to two percent inflation over the next couple of years. As we indicate in our statement, it’s something we’re watching very closely, considering risks around the inflation outlook,” Yellen said, during a question-and-answer session.
She added that monetary policy is not on a preset course. “We’re watching this very closely and stand ready to adjust our policy if it appears the inflation undershoot appears consistent.”
Markets took Yellen’s comments on inflation and on the Fed’s neutral rate to be dovish for interest rates. The Fed chair said while the Fed expects the neutral rate to rise, it won’t rise to historic levels, meaning the Fed won’t have to hike that much. The neutral rate is the level where rates do not either drive or hold back the economy.
The stock market rallied, pushing the Dow to a record high, and bonds also rallied, with yields falling. The 10-year Treasury was yielding 2.32 percent in afternoon trading, after falling below 2.30 percent initially when Yellen’s prepared remarks were released.
The Fed has targeted a 2 percent inflation rate. Its preferred inflation measure, the PCE deflator, was at 1.4 percent in May after briefly rising above 2 percent in February, thanks to a comparison with last year’s weaker energy prices.
Core CPI had been running above 2 percent throughout last year, but dipped several months ago and remains low. Economists expect core CPI to rise by 0.1 percent in June, or a 1.7 percent pace year-over-year.
“CPI core was above 2 percent for like 15 months in a row and the irony is the Fed never tightened through that,” said Peter Boockvar, chief market analyst at Lindsey Group. The Fed’s dual mandate is full employment and steady prices, and while the job market has been strong, inflation has been the laggard.
Boockvar isn’t optimistic for an improvement soon. “I think food prices all of a sudden could replace energy prices as an influence on headline inflation,” said Boockvar. Agricultural commodities have been rallying, and analysts expect those increases to show up in food prices.
Boockvar said the market ignored Yellen’s comments Wednesday on the Fed’s balance sheet unwind, which he said would be like a form of tightening. Strategists said interest rates could rise as the Fed slows down purchases of Treasurys and mortgages to replace those on its balance sheet that are expiring. The Fed has said it would pause its rate hikes while it starts the process.
That program is the last vestige of the Fed’s quantitative easing programs, which were asset purchases used to keep long-end interest rates low. The Fed’s balance sheet is about $4.5 trillion, and it’s expected to eventually shrink it by $1 trillion.
A number of Fed officials have been saying it could take steps to shrink the balance sheet and that it could raise rates one more time this year. The Fed is widely expected to take action on the balance sheet at its September meeting. But the markets focused on dovishness Wednesday, and expectations for a December interest rate hike faded slightly.
“The consensus is the Fed is wrong, and maybe the Fed is right this time. I think they’re viewing the balance sheet reduction and rate hike as the same effect,” said Jack Ablin, CIO at BMO Private Bank.
Ablin said the Fed could reverse its actions if the balance sheet adjustment causes problems. The Fed’s extraordinary easing took it into uncharted territory. The unwind is also untried.
“This isn’t a meteor coming from outer space. This is a self-contrived thing. I’m worried that a lot of the gains in growth can be directly attributed to the trillions of dollars the central banks printed and funneled into the market, but at the same time I don’t think it’s a foregone conclusion they’re going to close up shop and sell everything,” he said.
Boockvar said the market is too complacent about the balance sheet. “The Goldilocks interpretation of today’s Fed statement I think was a bit overdone,” said Boockvar. “I don’t know what the market interpreted as new. She said nothing new. It just shows you that the market is still obsessed with an easy Fed. As much as it has shrugged off the rate hike at the end of the year, they still like an an easy Fed. But she is still tightening the balance sheet. I think it’s a much bigger deal.”
Quantitative easing, or “QE was still a huge party every time it was going, and now we’re going to see the reverse and the market doesn’t care,” he said.
Yellen testifies at 9:30 a.m. Thursday. PPI is released at 8:30 a.m., as are weekly jobless claims. PPI is expected to show no change.
Fed Gov. Lael Brainard, who also commented on the neutral rate this week, speaks at 1 p.m.
Earnings are expected from Delta Air Lines and Commerce Bancshares. Infosys reports after the closing bell.