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FOMC Preview: Inflation in view as Fed expected to hold on rates

Brian Cheung

On Wednesday the Federal Reserve will make its third monetary policy decision of 2019. With a new GDP print showing another low reading on inflation, the Fed is expected to keep the benchmark interest rate steady at the current target range of 2.25% to 2.50%.

In March, the data-dependent Fed signaled no more rate hikes for the year amid tightening financial conditions and geopolitical concerns abroad. Since then, data has shown the economy chugging along as expected, with a robust March jobs report (shaking off concern over a weak February) and a GDP print that had the U.S. economy growing at an estimate-beating 3.2% in the first quarter.

The top-line number easily cleared expectations for 2.3% growth, propelled by higher private inventory investment, net exports, and state and local government spending.

But any worries over an overheating economy were tempered by a low reading on inflation; the core personal consumption expenditures index, the Fed’s preferred measure of inflation, grew a disappointing 1.6% in March. The Fed has persistently undershot its 2% inflation target and has cited tepid inflationary pressures as a reason to pause on rate hikes for the time being.

As of Wednesday morning, fed funds futures markets were pricing in a 97.5% chance of the Fed holding rates steady in the May 1 meeting, with only a 2.5% chance of the Fed cutting rates.

High Frequency Economics’ Jim O’Sullivan wrote Friday that “the move in core inflation is in the wrong direction from the perspective of Fed officials,” adding that the Fed should remain “firmly on hold” as a result of the GDP figure.

JPMorgan’s Michael Feroli said the solid GDP reading will likely lead the Fed to ditch its March description of the economy as having “slowed from its solid rate.” Feroli said inflation will be the main focal point amid “tepid” consumer spending growth.

Longer-term challenges

In addition to concerns over consumption, the GDP report also confirmed the persistence of slower growth in business fixed investment, a big driver for economic growth.

For the first quarter of 2019, business fixed investment grew by only 2.7% quarter-over-quarter. In the previous quarter of 2018, investment expanded 5.4% and in the first quarter of 2018, investment had grown 11.5%.

Although the data aren’t likely to change the Fed’s tenor on household spending and business fixed investment, the Fed may face questions regarding its estimates on output. In its March meeting policymakers projected economic growth in 2019 of 2.1%. Economists predicted that the U.S. would not be able to reach 3% growth amid slowing global growth and the waning effect of Trump tax cuts.

In this March 20, 2019, file photo Federal Reserve Chair Jerome Powell listens to a reporter's question during a news conference in Washington. (AP Photo/Susan Walsh, File)

In a heated note Friday, MUFG Union Bank’s Chris Rupkey wrote that Fed officials have “mud in their eye” for forecasting such low growth, noting that the Fed is “underplaying just how fast growth can be” in the face of 3.2% growth. He took issue with Fed officials who had warned of risks tilting toward the downside in justifying their near 2% GDP growth projections.

“Fed officials please stop scaring the public with your statements warning of ‘downside risks,’” Rupkey wrote. “There are no downside economic risks in today's GDP report, and this good news will be heard by markets around the world.”

Ian Shepherdson, chief economist at Pantheon Macroeconomics, wrote Friday that if the second quarter reading comes in just as hot, “the Fed is going to have a tricky summer.”

If government spending, inventories, and net exports can’t prop up the next GDP report, it is possible that GDP numbers could come in lower to bring output growth closer to the Fed’s projections.

The Fed will not be releasing updated economic projections in the May 1 meeting, but Fed Chair Jerome Powell will face reporter questions in the press conference.