Did the Fed forget to look at the February inflation report?

Core inflation may be heating up as the Fed is putting too much confidence in low energy prices.

Robert Johnson, CFA 21 March, 2016 | 5:00PM Roland Czerniawski

World equity markets stretched their weekly winning streak to five, with markets generally increasing between 0% and 3%, Europe hardly moving, and emerging markets gaining close to 3%. The U.S. Federal Reserve's reluctance to tighten further this week, combined with last week's European easing, powered the emerging-markets performance. On the other hand, the Fed's lack of action dulled the effects of moves the European Central Bank made last week and undercut Europe. Commodities also increased for the fifth week in a row, this week gaining about 1% as oil closed at almost US$40 per barrel. Both equities and oil prices, perhaps not by chance, bottomed the week ended Feb. 11. Interest rates, like Fed policy, were little changed on the week, although the 10-year U.S. Treasury bond yield fell modestly to 1.87%.

This week's price movements seemed primarily related to the Fed meeting on Wednesday. The Fed did not raise rates, which was expected, and a poll of individual governors seemed to indicate that most expected just two rate increases this year instead of the previous guesses of three or four. Most of the Fed's economic forecasts were little changed. It is expecting lower energy inflation, which it seems to believe will take off some of the pressure to raise interest rates sooner. However, this week's detailed inflation data grew more worrisome even as the headline report for February showed a seemingly tame deflation rate of 0.2%, driven almost entirely by falling energy prices, which are already rising again in March. Some inflation indicators, especially in the services sector, are approaching prerecession levels. In our opinion, the Fed is playing with inflationary fire. Other central bank easing programs and market volatility may have forced the U.S. Fed to the sidelines for now.

The inflation news was by far the biggest news of the week, but not fully appreciated by markets. Retail sales looked poor on a month-to-month basis and might even have looked worse if adjusted for inflation. Still, the monthly data has been surprisingly volatile while the year-over-year, averaged data remains rock-steady. Therefore, we are not sweating just yet. Some individual retail sales categories also looked quite strong, relieving at least some of the tension.

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Robert Johnson, CFA

Robert Johnson, CFA  Robert Johnson, CFA, is director of economic analysis for Morningstar.

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