US Bond Market Week In Review: The Fed Is Determined To Get Inflation Wrong

Today, the Federal Reserve issued their latest monetary policy statement, keeping rates at 1%-1.25%. They describe the economy as expanding moderately: the labor market continues to grow, households are spending and investment is picking up. But they once again argued inflation would reach 2% in the medium term. The evidence doesn’t support this conclusion. If the Fed raise rates later this year, they will be making a policy mistake.

Here are the three key passage about inflation from the release:

On a 12-month basis, overall inflation and the measure excluding food and energy prices have declined this year and are running below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.

.....

...inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee's 2 percent objective over the medium term

...

The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.

After noting that inflation is below their 2% target, they go on to argue that it will reach 2% in the medium term. They then argue that current low interest rates will aid in rising prices.

While the Fed has been making this argument for several years, inflation remains below their 2% target. Nothing in the current data supports their contention that prices will pick up soon.  Let’s start by looking at the commodity components of CPI:

Energy prices (in red) only recently started to increase on a Y/Y basis. But these only comprise 7% of CPI. Food prices (in blue) just turned positive. In the latest CPI release, they only rose 1.1%. The DBA agricultural ETF is in a 5-year downtrend, indicating food prices are soft. Other commodities (in green) have been mostly negative for the last five years. As these represent 19% of the CPI index, their contraction helps to mitigate any increase in food and energy prices. That leaves the services less energy to get inflation to the Fed’s 2% target:

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