Fed edges toward rate hike, but inflation is key variable

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The minutes of the Federal Reserve Board's most recent interest-rate meeting suggest that it is a lot closer to raising rates at its next meeting, in mid-June, than the financial markets have been thinking. Which may actually make a June hike a little less likely.

In the minutes of the April 26-27 meeting of the Fed's policy-setting Federal Open Market Committee (FMOC), made public on Wednesday, the committee made it quite clear it was happy with most aspects of the U.S. economy.

Strong job growth remains the shining beacon leading the U.S. recovery. Risks from the global economy and financial markets have retreated. Sure, U.S. gross domestic product barely grew at all in the first quarter, and household spending stumbled, but there was at least cautious optimism that this was a temporary blip, or perhaps even a flaw in the seasonal adjustments applied to these statistics in the winter months.

There was a general consensus that things were looking up for the second quarter and beyond, as job growth (and, by extension, income growth) fuelled a rebound from households and an acceleration in the economy as a whole.

The committee signalled that it wanted to see some more numbers to justify its confidence, but that it was keeping an open mind about a possible June rate hike – a long-awaited follow-up to its increase last December.

The one conspicuous barrier in the path of that hike, the minutes indicated, was inflation.

Despite whatever other positive signs the Fed was seeing, inflation remained stubbornly well below its 2-per-cent objective. And while the inflation picture was mixed, some committee members were clearly concerned that indicators of wage inflation remained muted, suggesting tepid underlying pressures on prices.

Inflation may be only one factor, but it's a doozy. The Fed's mandate is to maximize employment and achieve price stability (which it has effectively defined as pursuing 2-per-cent inflation). It is not an either/or; it is both. And while employment may be getting darned close to the objective (albeit with ample room for disagreement about under-employment indicators such as participation rates and involuntary part-time levels), the inflation goal still looks a long way off.

It has not got much closer since that April FOMC meeting. This week's consumer price index report showed that U.S. inflation had picked up in April, but was still a mere 1.1 per cent year over year. Higher fuel prices were a big reason for the acceleration; the core inflation measure, excluding the notoriously swingy food and energy segments, actually slipped slightly, to 2.1 per cent.

Other economic indicators since the April FOMC meeting are, at best, mixed. Retail sales picked up, but job growth slowed and initial jobless-benefit claims have risen. If the FOMC was looking for compelling evidence that the economy is springing back, propelling inflation toward its objective, April's numbers are not enough.

Perhaps the strongest argument at that April meeting for moving toward a rate increase earlier rather than later, even if that means jumping the gun on inflation, was one of market perceptions. Many members of the FOMC are worried that the Fed's message is being misunderstood – that market participants have taken a look at the Fed's cooling on rate hikes since the December increase, and the sluggish early-2016 economic data, and decided that we are not only unlikely to see a rate hike in June, but for many more months to come.

"Some [FOMC] members expressed concern that the likelihood implied by market pricing that the committee would increase the target range for the federal funds rate at the June meeting might be unduly low," the minutes said. "They emphasized the importance of communicating clearly over the inter-meeting period how the committee intends to respond to economic and financial developments."

But just by saying in the minutes that the market may be taking the possibility of a June rate hike too lightly, the Fed has quickly alleviated the problem. As of late Wednesday, the bond market was pricing in a 30-per-cent probability that the Fed will raise rates at the mid-June meeting, up from 12 per cent before the minutes were released and near-zero when the week began. Message received, it would seem.

This is probably about as much action as we can expect from the Fed for the time being, and, indeed, through the June meeting. The nagging inflation question, abetted by a mix of not entirely convincing economic indicators, will keep a rate hike at bay. But the Fed will likely fill the void with plenty of talk to bring market expectations back up to speed, and keep them there.

Once the Fed has the market at something close to a 50-50 bet on a rate hike at any given FOMC meeting, it will have a green light to let the inflation trend have the final say.