MNI PREVIEW: Fed To Stay Patient; Inflation Slowdown Key Risk

By Jean Yung

     WASHINGTON (MNI) - Federal Reserve officials are likely to reaffirm their

2.25% to 2.50% target range for the fed funds rate as well as their message of

patience in adjusting policy at next week's FOMC meeting, even as the worst

global and financial fears have faded in recent weeks.

     The U.S. economy appears on track for a soft landing after the FOMC

suspended its three-year tightening campaign in January. Chinese growth is

stabilizing, Brexit has again been delayed, and the S&P500 rose to a new

all-time high this week. Yet, markets still expect a Fed rate cut in the coming

year due in part to concerns over tepid inflation.

     Sub-2% core inflation readings and a fall in inflation expectations at a

time of above-trend growth and strong labor markets have confounded

policymakers. Chair Jay Powell has initiated a review of the Fed's inflation

framework to investigate the potential tradeoffs if the central bank were to

commit to achieving above-target inflation following periods of

underperformance.

     Should core inflation slow further this year, the FOMC may need to consider

cutting rates pre-emptively to prop up inflation and inflation expectations even

absent sustained signs of broader economic deterioration.

     Policymakers will also continue to debate the ultimate composition of the

Fed's asset portfolio and the recent funding pressures that have pushed the fed

funds rate further above the interest rate on excess reserves and closer to the

top of the target range.

     --PARTING CLOUDS

     Officials have hinted interest rates might stay on hold through the end of

the year if not through 2020, citing "global economic and financial developments

and muted inflation pressures" as reasons to be patient, but Powell can report a

better outlook on the first two factors next week.

     Compared to earlier in the year, the "crosscurrents" of slowing global

growth, elevated policy uncertainty and tighter financial conditions against

otherwise solid U.S. fundamentals have let up considerably. A turnaround in

China is a good sign, and investors are hopeful for springtime progress on a

U.S.-China trade deal.

     Meanwhile, domestic data have bounced back, restoring confidence in

consumer spending and jobs and quieting recession chatter. First-quarter GDP

growth was surprisingly strong at 3.2% on higher exports and an increase in

inventories, above the 2.2% reported for the fourth quarter and better than many

had expected in light of year-end market turmoil and a record-long U.S.

government shutdown in January. Consumer spending was a tad better than

expected.

     Richmond Fed research director Kartik Athreya said in a recent interview

that domestic risks look benign and a brief yield curve inversion in March may

not accurately predict a near-term recession, given negative risk premia.

     --INFLATION SUBDUED

     The FOMC has set a high bar for resuming interest rate hikes, with Powell

noting in January that he would need to see progress on inflation specifically.

So far, the data have shown few signs that inflation can mount a sustained

return to the Fed's 2% target later this year.

     Core PCE inflation was 1.7% in the first quarter, with the Cleveland Fed's

Inflation Nowcast predicting a deceleration to 1.6% by April. That's a shift in

tone from last summer, when core PCE inflation hit a recent high of 2.0% with

three- and six-month changes indicating some acceleration.

     The University of Michigan's survey of inflation expectations was also

discouraging, finding that consumers in April expected inflation over the next

five to 10 years to be 2.3%, matching all-time survey lows.

     A preemptive rate cut would be one way of helping to anchor expectations at

2%. Officials are also considering alternative targeting frameworks, including

one which would tolerate modest inflation overshoots to make up for shortfalls

in future slowdowns. Alternative strategies will be among the topics of

discussion at an upcoming conference devoted to a broad review of the Fed's

monetary policy strategies.

     --BALANCE SHEET ISSUES

     Beyond rate policy, the FOMC is expected to continue the debate on balance

sheet strategies.

     Officials will mull over how quickly to shed mortgage-backed securities

from the Fed's balance sheet and normalize the long-run composition of its

Treasury holdings, which now excludes bills.

     The Fed wants to boost its holdings of short-term securities to give itself

flexibility to stimulate growth in another downturn, but officials are wary of

moving too quickly for fear of distorting markets, Philadelphia Fed economist

Roc Armenter told MNI this month.

     No immediate decision is expected.

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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