US inflation outlook turns cloudy

When the FOMC met in late July, there was a notable lack of consensus on the timing of the first rate hike. In fact, some participants doubted that there would soon be enough evidence that inflation will move back to target over the medium term. The minutes of that meeting contained several references to concerns about the impact of the strong dollar and declines in commodity prices on the inflation outlook. There were also several references to the lack of wage and price pressures despite the falling slack in the labour market. So while the Committee was pleased with continued progress in the labour market, there were strong reservations about the other part of the dual mandate by the end of July. 

The developments in August are not likely to have increased the doves' confidence in the inflation outlook. The slowdown of the Chinese economy, the devaluation of the yuan against the US dollar, and the worldwide decline in commodity prices could further delay the return of US inflation to its 2% target. The Fed's preferred measure of inflation, the PCE deflator, remained at 0.3% year-on-year in July, but the core measure fell to 1.2% year-on-year, after being steady at 1.3% in the first six months of the year. This suggests that it may take longer for the headline figure to return to the Fed's 2% target. With this lack of consensus on the timing of the first rate hike, and the many doubts about the inflation outlook, a September rate hike is less likely than a first rate increase in December. Labour market progress is on track, but there will probably not be a majority in the FOMC with 'reasonable confidence' in the inflation outlook by September. Where the events in August have reduced the probability of a September rate hike, they have increased the probability that the first hike will be delayed until 2016. 

"We still think that December is the most likely date for the Fed's policy rate lift-off. However, instead of the main risk to our outlook being an earlier hike, it has increasingly become a later hike", says Rabobank.