Inflation, or lack of it, now the indicator to watch on Federal Reserve's rate rise path

The US Federal Reserve Building in Washington, DC.
The US Federal Reserve Building in Washington, DC. PHOTO: AFP

WASHINGTON (BLOOMBERG) - Inflation - or the lack of it - is now the must-watch indicator to help determine the pace of US Federal Reserve interest rate increases.

If there were any doubts about the role price pressures will play in the Fed's decision-making, the minutes of the latest Federal Open Market Committee meeting, released on Wednesday (Jan 6), dispelled them.

A large part of the debate revolved around downside risks to inflation, even though officials said they were "reasonably confident" they'd reach their goal over the medium term, the minutes showed.

"The Fed's focus is now really on inflation," said Mr Donald Ellenberger, a senior portfolio manager who oversees about US$10 billion (S$14.3 billion) of client money at Federated Investors. "That's going to be the real focus for the markets going forward."

The US central bank has missed its 2 per cent inflation target for more than three years as slumping oil and commodities and a stronger US dollar kept a lid on prices. The personal consumption expenditures price index, minus food and energy, rose just 1.3 per cent for the 12 months ending November. The Fed bases its target on the full index, which rose 0.4 per cent over the period.

While the majority of the committee continued to bank on a forecast that sees inflation rising to their goal by 2018, the minutes contained several warnings from a group of more dovish officials who did not share this confidence.

"For some members, the risks attending their inflation forecasts remained considerable," the minutes said. "Among those risks was the possibility that additional downward shocks to prices of oil and other commodities or a sustained rise in the exchange value of the dollar could delay or diminish the expected upturn in inflation."

Even further strength in the labour market, where the 5 per cent jobless rate is almost at Fed officials' definition of full employment, "might not prove sufficient to offset the downward pressures from global dis-inflationary forces", a couple of officials said.

The FOMC summed up its strategy for future rate hikes in a single word: gradual. However, for the near term outlook that word can mean many things - such as two additional hikes this year or four.

Mr Michael Gapen, chief US economist at Barclays Capital, says the inflation data will determine the pace and that means three hikes this year starting in March.

By June, however, they will see that import prices are suppressing core inflation measures, forcing Fed officials to revise their outlook and skip a hike at that meeting, he said. They will raise again in September and December, Mr Gapen said in an interview.

The minutes listed five separate reasons why a gradual pace of rate increases was "appropriate." While low inflation comprised two of those, the discussion fell short of communicating a strategy on how the committee might change its expectations for the path of interest rates if inflation fell short of its forecast. Fed officials project four quarter-point hikes this year, according to the median estimate of forecasts prepared for the December meeting.

"Gradual is not a strategy," said Dr Andrew Levin, an economics professor at Dartmouth College and former adviser to Fed chair Janet Yellen. "They don't have any agreement within the committee about a strategy, and since there is no agreement, they don't have any coherent way to communicate a plan or the contingencies for adjusting it in response to the data."

Dr Levin said that means Ms Yellen has to follow an "old-style approach" of seeking a consensus on a meeting-by-meeting basis and then trying to explain each of those decisions at her quarterly press conferences.