Thursday, January 5, 2017

Five graphs for 2017: #2, inflation and the Fed funds rate

 - by New Deal democrat

This is the fourth of five metrics I'll be paying particular attention to this year.

The first three are the "troika" of issues that could lay the basis for the next recession: higher gas prices (#5), a surge in the value of the US$ (#4), and higher interest rates (#3).

At least 2 of the above 3 metrics are connected to the inflation rate.  For the last 16 years, the waxing and waning of consumer inflation has primarily been driven by gas prices.  Further, the spike in interest rates appears to reflect a belief that the actions taken by the incoming Administration in Washington will be inflationary.

Against that backdrop, we have a Fed that officially has a "target" of 2% inflation, but in practice appears to treat 2% as a ceiling.  It did not appear concerned at all by the nonexistent inflation of 2015, but since 2014 at least has been talking of calibrating interest rates to achieve a"gliding into" the 2% inflation target.

So graph #2 for 2017 is YoY CPI and the Fed Funds rate.  Here it is for the last 50 years:

Typically the Fed has chased late cycle inflation higher.

Here's a close-up of the last 5 years:

If consumer inflation, driven by an increase in gas prices, goes over 2% in the next few months (which I consider likely), the Fed certainly sounds like it will chase it, and raise interest rates multiple times.  If so, that will set the stage for the narrowing of the currently relatively steep yield curve.

[Note:  since tomorrow is the jobs report, I will post the #1 graph next week.]