Bank of the West U.S. Outlook Report for August 21, 2015

Bank of the West US Outlook Report: Conflicting Signals from the Fed Minutes

Bond investors, parsing the FOMC minutes from the July meeting, sensed hesitation about the timing of the first interest rate hike from the Fed and have since soundly convinced themselves that a move in September is virtually off the table. The Fed funds futures implied probability of a rate hike in September fell from around 50% prior to the Fed minutes release to 34% on Thursday. But, I still believe the real probability of a September versus a December move is close to 50-50 with a slight nod in favor of a September move.

Indeed, there is plenty of opportunity for better U.S. economic data in the weeks ahead to turn investors’ minds on a dime again. Bond investors could prove to be as fickle as likely voters in the next Presidential election appear to be this campaign season.  For example, next week we get the second estimate of second quarter GDP. We anticipate a solid upward revision to 3.3% from 2.3%.  Consumer spending, structures, residential investment, equipment spending, inventories, and net exports should all see upward revisions from the initial release. Moreover, new home sales, consumer confidence, and personal income and spending all released next week are forecast to show solid monthly gains as well.  Even so, the August payroll report released in September will be the weightiest piece of evidence for investors to mull over.

The FOMC statements themselves have said that members need to be “reasonably confident” that inflation will return to its target over the medium-term.  Though it is important to note that Chair Yellen herself has said at past FOMC press conferences that this statement does not mean they need to see higher inflation before an initial rate increase, just confidence it will turn higher will be sufficient.

So let me point out a couple to positive inflation trends that you might not be aware of and seem to fly in the face of all this downbeat focus on the US dollar and declining oil prices.  First, since the December low, PCE inflation excluding food and energy on a monthly compound annualized basis has accelerated and even remained above trend since February.  So there is evidence of an improving trend even with the Fed’s preferred measure of inflation. This could be all the evidence the FOMC needs to start the normalization process. The rebound in overall PCE inflation on an annualized monthly basis has been even stronger. This appears to support the Fed’s view that the shortfall in inflation is temporary and once energy prices stabilize, inflation will bounce back.

Conflicting signals from inflation and from the Fed itself ensure a nail bitter at the September FOMC. If I had a vote on the committee, my vote would be to begin liftoff in September despite market volatility –Stay Tuned.

To find out more, check out this week’s US Outlook report.