Economist warns: 'Once again, the Fed's credibility is on the line'

Nicole Sinclair
Markets Correspondent
Federal Reserve Chair Janet Yellen. (AP Photo/Cliff Owen)

On Wednesday, the Federal Reserve hiked rates for the second time in this year, as expected, bringing the target for the federal funds rate up 25 basis points to 1.0-1.25%.

Stifel Fixed Income Chief Economist Lindsey Piegza went so far to suggest that “the Fed’s credibility is on the line as the data argues for quite an opposite position.”

Data released Wednesday morning showed core consumer price inflation grew only 1.7% year-over-year in May, the smallest increase since May 2015. The Fed has long had a 2% inflation target and its preferred measure of inflation, PCE (Personal Consumption Expenditures), currently stands at 1.5%.

In theory, by tightening monetary policy through rate hikes, the Fed further puts pressure on prices. This puts the economy at risk of seeing price deflation. Concerns are exacerbated by the fact that recent economic data reflects weakness due to sluggish consumer spending activity.

“The Fed’s decision to move forward with a second-round increase this year appears to be motivated by both a push from the market with today’s rate hike fully priced in…as well as a desire to rebuild the monetary policy tool kit,” Piegza wrote. “Without sizable and clear additional weakness, the Fed appears steadfast in their commitment to one additional rate hike this year…The data argues for quite an opposite position.”

Data can be “noisy”

Following the consumer price numbers on Wednesday morning, fed funds futures contracts showed that the probability of a third hike in 2017 dropped from 48% to 28%.

But Fed Chair Janet Yellen said on Wednesday afternoon that weak inflation readings won’t persist and provided an upbeat outlook on the economy.

“We continue to feel with a strong labor market and a labor market that continues to strengthen, conditions are in place for inflation to move up,” Yellen said during the press conference Wednesday afternoon.

Fed officials maintained estimates for one more rate hike in 2017, for a total of three. In addition, the Fed said it expects to begin reducing its balance sheet this year.

“The committee currently expects to begin implementing a balance sheet normalization process this year, provided the economy evolves broadly as anticipated,” according to the Fed’s statement.

While Yellen said the Committee will be monitoring inflation, she added she is not concerned at this point by low readings, particularly in light of what she termed a tight labor market. (The unemployment rate dropped to 4.3% for the month of May).

“It’s important not to react to a few readings…Data on inflation can be noisy,” Yellen said, specifically mentioning dropping cell phone prices and declines in prescription drugs.

Yellen added during her press conference that the strong labor market has created the conditions needed for inflation to increase. And she added that the Phillips Curve—which shows that inflation and unemployment have a stable inverse relationship—is still in place.

While many analysts argued on Wednesday that the Fed is at odds with the data, some pointed to the Fed’s desire to move toward policy normalization ahead of its anticipated unwinding of its $4.5 trillion balance sheet.

“The committee also has a strong desire to start a balance sheet runoff this year; too dovish a message would run counter to this objective,” according to Barclays’ Michael Gapen.

Nicole Sinclair is markets correspondent for Yahoo Finance

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