Rate Hike Expected As Fed Signals It Will Allow Higher Inflation

The Federal Reserve is prepared to let inflation run above its two-percent target, according to the minutes of its policy meeting held earlier this month. The bond market appears comfortable with the news: the implied inflation forecast based on the yield spread between nominal and inflation-indexed Treasuries ticked lower yesterday, reaching the lowest level in over a month for the 10-year maturities. Meanwhile, the crowd continues to bet that the central bank will continue to raise interest rates, including a hike at next month’s FOMC meeting. A period of dovish tightening, in other words, prevails.

Fed funds futures are currently pricing in a 90% probability that rates will be increased at the June 13 policy conference, based on CME data this morning (May 24). The outlook calls for a near certainty that the bank’s target rate will rise 25 basis points to a 1.75%-to-2.0% range.

The next round of expected policy tightening accompanies a Federal Reserve that appears unworried about inflation. According to the minutes released yesterday for the May 1-2 meeting:

A few participants commented that recent news o inflation, against a background of continued prospects for a solid pace of economic growth, supported the view that inflation on a 12-month basis would likely move slightly above the Committee’s 2 percent objective for a time. It was also noted that a temporary period of inflation modestly above 2 percent would be consistent with the Committee’s symmetric inflation objective and could be helpful in anchoring longer-run inflation expectations at a level consistent with that objective.

Consumer price inflation is already running above 2%. The headline rate increased 2.5% in the year through April while the core increase (less energy and food) advanced 2.1% over the past 12 months.

The Treasury market doesn’t appear concerned that the Fed is letting pricing pressure run too hot. The implied inflation forecast, based on the yield spread for the nominal less inflation-indexed 5-year maturities, slipped to 2.12% on Wednesday, a two-week low. For the 10-year rates, the inflation forecast fell to 2.14%, the lowest in more than a month.

The market, it seems, approves of the Fed’s efforts to strike a balance with rate hikes and managing inflation, based on the latest rally in Treasuries (rates fall when bond prices rise). But some of the increased appetite for US government bonds reflects a jump in demand for safety this week as various risks percolate around the world, ranging from concerns that emerging markets are vulnerable to rising US interest rates to fresh uncertainty in Europe amid the emergence of a populist government in Italy.

There’s always something to worry about, of course. But the real test for judging the Treasury market’s reaction to the Fed’s dovish tolerance for higher inflation is yet to come. In fact, a timely stress test awaits in the May report for consumer prices, scheduled for release on June 12 – the day before the Fed’s policy announcement.

For the moment, the central bank’s gradual tightening has the approval of Treasury market. But with inflation trending higher and running above the Fed’s 2.0% target, it’s reasonable to assume that the crowd’s tolerance for upside surprises is limited.