New Dilemma at the Federal Reserve

The second day of the Federal Reserve’s Open Market Committee concludes later today and the big question is whether or not they will drop the term ‘considerable time’ from their forward guidance statement.

The phrase has denoted how long the Fed expects to wait between the end of quantitative easing and the beginning of actual interest rates hikes. Earlier this year, Yellen indicated that ‘considerable time’ refers to six months and with the bond buying program now over, that suggests that the Fed would likely raise rates this summer.

There have been a number of back and forth debates about the timing of the hikes, with hawks calling for hikes sooner to get rates back to something closer to normal and the doves who seem willing to leave rates lower for longer.

Today, there are two relatively new, powerful forces that will play into the Fed’s decision: substantially lower oil prices and a much stronger dollar. Since the end of July, oil prices have fallen by nearly 45 percent and the dollar is up nearly 10 percent.

Oil prices directly impact the headline inflation rate that includes food and energy prices, but oil prices also affect core rates since energy is an input cost that businesses should pass on to consumers over time.

The strong dollar will also impact inflation because it lowers the price of imports.

Imagine that a Japanese car manufacturer is selling cars in Japan for 5.1 million yen. At the end of July, that translated into $50,000. Today, that same 5.1 million yen implies that the car should sell for $43,600. The real world doesn’t work exactly like this, but hopefully, it gets the idea across.

So now the Fed has two prevailing factors pushing inflation expectations sharply lower. In July, the bond market implied that inflation over the next five years would be around two percent. With oil and dollar behaving as they are, the inflation expectations have fallen sharply to roughly 1.1 percent over the next five years.

That’s a pretty amazing shift if you think about it. In less than six months, inflation expectations over the next five years have been almost cut in half. It’s the kind of data that the Fed can’t ignore.

The hawks, who are so worried about the risk of inflation, don’t have much of a leg to stand on right now. Inflation may show up in the future, but there is no sign of inflation today and the market doesn’t expect any in the next five years.

That leaves the Fed more likely to keep interest rates lower for longer in my view. They’ve always said that they would be ‘data dependent’ and I think it’s fair to say that we have new data. Six months ago, there was no consensus that oil prices would drop so sharply or that the dollar would perform so strongly.

The Fed has also indicated in the past that they view commodities prices as highly volatile, temporary effects, which means that they could downplay what’s happened recently and take a longer-term view.

When the news comes out, the initial story will be about whether ‘considerable time’ is still in the guidance or was replaced by something else.

Once that brouhaha is settled, it will be interesting to see what the Fed has to say about inflation and how that might affect the timing of interest rate hikes.