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Fed officials have long argued that inflation has been soft n primarily due to
transitory factors and would eventually rise as these influences faded and the
labor market tightened. Over the last half year, inflation has picked up
substantially in a manner that closely fits the Fed’s narrative. Yet at the March
FOMC meeting, both the Committee’s inflation projections and comments from
Chair Yellen suggested a puzzlingly skeptical take on the encouraging recent data.
n We see three broad reasons for the skepticism of some FOMC participants.
First, some see the recent pick-up as largely reflecting idiosyncratic one-off
factors that are unlikely to persist. Second, others likely see downside risks from
recent declines in inflation expectations. Third, some participants likely expect
further drag from past or future dollar appreciation. Simulations using an inflation
model described by Chair Yellen suggest that the latter two factors likely account
for the FOMC’s soft inflation forecast, though we do not share their degree of
concern.
n In our view, the FOMC had it right the first time. We expect disinflationary forces
to fade further this year, while inflationary pressures should strengthen as the
labor market continues to tighten, a process already apparent at the local level.
As a result, we expect core PCE inflation to reach 1.8% by 2016Q4, 0.2pp above
the FOMC’s projection, and headline PCE inflation to reach 1.5%, 0.3pp above the
FOMC’s projection.
n At the time of liftoff, the FOMC viewed a pick-up in core inflation to 1.6% by the
end of 2016 as sufficient progress toward its target to justify four additional hikes.
As the year progresses, we expect that the FOMC will gradually revise up its
inflation projections and ultimately conclude that an even stronger acceleration to
1.8% merits three hikes this year rather than two.
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