What Real Rates Are Saying About Economy

Back in the summer of 2018, inflation estimates were riding high as economists expected the Fed to hike rates 3 times in 2019. Everything changed when the economy started slowing, energy prices crashed, and the Fed balked at the idea of raising rates at all as they introduced the word “patience”. The 10-year treasury yield has fallen to 2.60% which means if the Fed were to raise rates, it could invert more of the yield curve, with the Fed funds rate being potentially above the 10-year yield.

Of course, the Fed is highly unlikely to raise rates in this environment as the Fed fund futures market shows there is a zero percent chance of a hike this year. The Fed fund futures market isn’t accurate when you start talking about a few quarters of policy in advance, but it’s still important to know what the market expects for all time frames. That’s the first step in making bets. The February PPI reading was the last inflation reading the Fed will get before its March 20th meeting where there is no chance of a hike and a 1.3% chance of a cut.

PPI Shows Inflation Slowing

The PPI report showed headline yearly inflation fell from 2% to 1.9%. PPI without food and energy fell from 2.6% to 2.5%. Finally, inflation without food, energy, and transportation fell from 2.5% to 2.3%. This signals March CPI could be weaker than February as PPI is the producer’s measurement of inflation which means it leads consumer prices. One interesting part of the PPI report is that consumer food prices fell 0.4% monthly. In the February CPI report, yearly food inflation was 2% which was the highest reading since April 2015. If food price inflation weakens, that will further suppress headline inflation which has already been below core inflation.

Core PCE Expected To Be Weak

The chart below shows the probability distribution of core PCE inflation at the next few Fed meetings. As you can see, few economists are projecting inflation to be above the Fed’s 2% target for the June and September 2019 meetings.

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