A worrisome decline in the Treasury market’s implied inflation forecasts that began last October appeared to stabilize in the new year. But over the last week the downside bias has returned, raising questions about monetary policy ahead of tomorrow’s Federal Reserve’s policy meeting (Jan. 30), which will unveil new forecasts, a possible but unlikely change in interest rates and a press conference by Fed Chairman Jerome Powell.

The latest dip in Treasury inflation estimates is slight, but the so-far mild downturn of late follows several months of persistently lower projections and so it’s fair to say that the market’s outlook for pricing pressure remains substantially discounted compared with prevailing conditions as recently as three months ago. For example, the implied inflation forecast via the yield on the nominal 5-year Note less its inflation-indexed counterpart fell from nearly 2.1% in early October to just below 1.5% at the start of 2019.

As the new year has unfolded, the inflation estimates rebounded, but it now appears that the bounce was temporary and the downward trend has resumed. The 5-year forecast ended yesterday (Jan. 28) at 1.62%, close to the lowest level so far in 2019, based on daily data published by Treasury.gov.

Narayana Kocherlakota, a former president of the Federal Reserve Bank of Minneapolis, advises that “the Fed has been falling short — arguably well short — of both its inflation and employment mandates for a long time… With a potential slowdown coming in both US inflation and global growth, that means thinking about lowering interest rates rather than increasing them.”

A cut isn’t expected for tomorrow’s policy announcement. Fed funds futures are pricing in a virtual certainty that the Fed will leave its target rate unchanged at the current 2.25%-to-2.50% range, according to CME data. For the rest of the year, in fact, the futures market is expecting no change in the policy rate.

The Congressional Budget Office thinks otherwise. In the new outlook for economic and budget data, the organization announced: “CBO expects the Federal Reserve to continue to raise the target range for the federal funds rate (the interest rate that financial institutions charge each other for overnight loans of their monetary reserves) in 2019.”

But the case for continued rate hikes has weakened lately, in part because economic growth has slowed. As The Capital Spectator reported last week, a recent set of nowcasts point to a second downshift in quarterly GDP growth for 2018’s fourth quarter. Recession risk is still low, but the US macro trend has decelerated and the near-term prospects appear low at the moment that output will pick up.

As always, the incoming data could change the calculus, but on several key fronts, the signs are pointing to a softer trend. That includes housing – notably, existing home sales fell sharply in December, pushing the year-over-year change to a troubling 10.3% decline.

Meanwhile, the Federal Reserve faces a tricky period with its plans to wind down its bloated balance sheet that was built when quantitative easing was in full swing in recent years. As Reuters explains:

Federal Reserve Chairman Jerome Powell has a problem: how to explain that the Fed may soon begin to taper its ongoing asset-shedding operation without looking like he’s hunkering down for a coming recession, or caving to U.S. President Donald Trump.

A key challenge for 2019 is that even if interest rates remain stable the Fed appears set to engineer a degree of monetary tightening by trimming its balance sheet. As Reuters reminds, “even if rates remain steady this year, the ongoing shedding of assets, including some $380 billion since October 2017, will continue to tighten financial conditions by making funding more expensive for banks.”

Nonetheless, veteran Fed watch Tim Duy, an economist at the University of Oregon, expects that “the underlying data will still prove too strong for central bankers to signal that they are at the end of the rate cycle.”

Perhaps, but if the Treasury market’s inflation forecast continues to decline, the slide will be a sign that pressure is rising on the Fed to rethink its policy plans. A key number to watch in the weeks ahead on that front: If the 5-year Treasury inflation forecast falls below its previous low – 1.49%. In that case, chatter will heat up regarding the merits for cutting rates.