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Fed Ready To Unwind, Shrugs Off Inflation 'Mystery'

Despite cutting its inflation forecasts for the next two years to well below its 2% target, the US Federal Reserve has lined up four more rate rises between now and the end of 2018, as well as kicking off the winding back of its huge $US4.5 billion balance sheet.

While acknowledging the damage caused by two recent hurricanes (with a third monster storm, Maria, looming), most Fed members overnight Wednesday stuck with forecasts for another rate rise in 2017 — most likely in December — as well as three further increases in 2018.

The news of the balance sheet wind back had been widely expected from the two day meeting, while the estimate of four more rate rises in the next 15 months was a bit of a surprise.

But that didn’t hurt sentiment on Wall Street where the Dow and the S&P eked out smallish gains, while Nasdaq fell.

The S&P 500 closed 1.59 points, or less than 0.1%, higher at 2,508.24. The Nasdaq lost 5.28 points, or less than 0.1%, to 6,456.04, but the Dow stood out with a 41.79 points, or 0.2% gain, to 22,412.59.

Gold fell half a per cent to $US1.304 an ounce, but US crude futures topped the $US50 a barrel level for a 1.6% gain on the day.

In Australia the local market will open weaker with a tiny loss on the ASX200 futures market.

In a unanimous decision, the Fed said it would start ‘normalising’ its balance sheet next month, or in nine days time and start reversing its policy of quantitative easing.

It means the Fed joints two other central banks in ‘normalising' policy. The European Central Bank has recently indicated that it will wind down its asset purchases as it responds to firmer growth in the euro area, while the Bank of England has suggested it could lift short-term rates this year in response to rising inflation risks.

The upswing in the global economy this year has helped justify the Fed’s two rate rises this year and the two before it.

Falling unemployment in major advanced economies and steady growth have reduced the need for emergency levels of monetary support.

But as we saw with the latest forecasts from the Fed, inflation is not responding in the way textbooks and conventional thinking says it should in times of tightening labour markets.

Wages growth remains weak (the 2.5% rate in the US is among the highest in the major economies at the moment and compares with Australia's 1.9%).

US inflation for example, as measured by the Fed’s referred indicator - the Personal Consumption Expenditure Index (Or PCE Index) has not touched 2% (The Fed’s target) at any time in the past five years and according to the latest forecasts, will not do so in the next two.

While the US The Consumer Price Index jumped in August, that followed five months of weak and declining readings. While it will probably kick higher in the next couple months thanks to the impact of the hurricanes on energy and food rices, those rises will be temporary.

In fact the Fed’s policymakers do now not expect core inflation to hit the 2% target until 2019, compared with 2018 previously.

The median forecast for core personal consumption expenditures (PCE) — the Fed’s preferred inflation measure — was lowered to 1.5% in 2017 from 1.7%, and 1.9% in 2018, from 2% previously.

Fed Chair Janet Yellen told a post meeting media conference this morning that the Open Market Committee believes the recovery was on a “strong track” and that slack in the labour market had largely disappeared. A tighter labour market tends gradually to push up wage and price growth, she said (a familiar refrain).

But Ms Yellen conceded that the shortfalls in inflation this year had been something of a mystery and it was not easy to point to a set of factors that explain why it has been so low.

For much of the year she and other Fed members had dismissed the weak price pressures as being “transitory” and due to one offs such as cuts to the price of mobile phone packages.

The chair told the media that the Fed would determine whether the factors that have lowered inflation are persistent or merely transitory based on the incoming data - a stance she is still clinging to in some way.

But the Fed isn’t all that confident about the inflation outlook - like central banks elsewhere (including Australia) the weak inflationary pressures and weak wages growth amid strengthening labor markets is not found in the textbooks.

In fact Fed members have trimmed their estimates for official rates in the long term, cutting it from 3% to 2.8%. With four rate rises pencilled in over the next 15 months, the Fed could be finished the bulk of its increases by the end of next year.

View More Articles By Glenn Dyer

Glenn Dyer has been a finance journalist and TV producer for more than 40 years. He has worked at Maxwell Newton Publications, Queensland Newspapers, AAP, The Australian Financial Review, The Nine Network and Crikey.

At the AFR he was a finance writer, Finance Editor, News Editor and Chief of Staff. At the Nine Network he was supervising producer of Business Sunday for more than 16 years. He has also written for other online and analogue print publications here and overseas.



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