Roger J Kerr believes markets will be forced to change their current stance and move future pricing of interest rates to higher levels

By Roger J Kerr

There is now a fierce debate going on between the financial markets and the US Federal Reserve as to whether the recent fall in US inflation is more permanent or merely temporary.

As confirmed in last week’s FOMC statement, the Fed firmly believe that the lower inflation over recent months in the US is just transitory and will reverse back upwards later in the year/early next year.

The bond and FX markets still do not believe that this is the case and that is why 10-year Treasury Bond yields remain lower at 2.15% and the US dollar has weakened to $1.1200 against the Euro.

The markets continue to price-in a stronger probability that the Fed will be forced to change their view and reduce the number of interest rate hikes planned for 2018.

The markets are currently pricing-in just one 0.25% increase for interest rates in 2018.

The Fed say one 0.25% increase in about September this year and three more 0.25% hikes next year.

US consumer prices that have decreased over recent months, and which have caused the inflation index measures to decrease, include house prices, rents, used automobiles and commodity prices.

The debate is all about whether these price reductions are temporary or permanent.

The way the interest rate markets are pricing forward interest rate rates (see the five year swap interest rate in five years’ time chart below that is a surrogate for inflationary expectations) suggests continuing falls in the annual inflation rate.

The markets priced the same lower trajectory in early 2016 and were proved wrong with inflation increasing through the year.

My pick is that the Fed will win this debate and the markets will be forced to change their future pricing of interest rates to higher levels.

The lead-indicators for future inflation are employment and wages.

The Fed are obviously expecting the strong labour market in the US (low unemployment levels) to continue and this always feeds into higher wages and thus inflation.

Technological advancement may be challenging that economic paradigm, however the maxim holds in my opinion.

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Roger J Kerr contracts to PwC in the treasury advisory area. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com