Inflation drop may be at core of case for Fed rate cuts

WASHINGTON (Reuters) - June 2018 was a blue-sky month for the Federal Reserve, with strong economic growth, low unemployment, and inflation expected to top the U.S. central bank's 2% target for the year - smooth sailing for an interest rate hike then and two more over the following six months.

It has been downhill since, with inflation sliding back to the turgid levels the Fed has fought against since the 2007-2009 financial crisis and recession, and the central bank poised to reverse course with rate cuts this year.

Trade and global growth may have dominated Fed Chairman Jerome Powell's narrative for why he and his colleagues shifted expectations that, even as of last December, had the Fed continuing to raise rates.

But it is the slide in inflation that may be the more chronic concern as the Fed now sees the rate of price increases as measured by the personal consumption expenditures (PCE) price index hitting only 1.5% this year, and to remain below 2% through 2020 as well. If that transpires, the Fed will have missed its inflation target for eight years running.

"I think they are very worried and with good cause that this could over time lead to a downward drift in expectations," and make it harder to raise inflation in the future, said Nathan Sheets, chief economist with PGIM Fixed Income and a former Fed staffer. Though the outlook around trade has been erratic, "there is no asterisk on the inflation target - '2% when (trade) policy is benign and stable.' It is not categorical."

After weeks in which markets reacted to new tariff threats from the White House and built Fed rate cuts into bond pricing, the central bank on Wednesday signaled it was ready to play ball. New projections showed most Fed policymakers trimming roughly half a percentage point from their outlook for the appropriate level of the benchmark overnight interest rate at the end of 2019.

In the coming weeks they will be watching fresh U.S. economic data and the outcome of a Group of 20 nations summit where President Donald Trump and Chinese President Xi Jinping are expected to meet, as they debate whether to move forward with a rate cut and, if so, by how much.

Graphic: The Fed's lost accommodation , clickhttps://tmsnrt.rs/2RoYEzb

FED'S CREDIBILITY

The threat of weak or falling inflation has been with policymakers far longer, and arguably poses an even larger problem that tests not only their understanding of the economy, but their credibility as well. Since adopting a 2% inflation target in 2012, the Fed has always said it would hit it in the medium term - and so far, except for a period in 2018, pretty much always has been wrong.

Considered an important way to keep consumers and businesses forward-looking and willing to spend, the inflation target is now the subject of a year-long Fed review of how officials can do better at meeting it.

In his press conference following the end of the latest two-day policy meeting on Wednesday, Powell noted the concern that weak inflation could become "sustained," dropping his previous description of it as "transient."

After peaking at 2.1% in the economic projections issued in September, the outlook for PCE inflation has fallen in each quarterly set of projections since.

It's an outcome that is likely to raise new questions about whether the Fed's four rate hikes last year were a mistake that helped knock progress toward the inflation target off course.

"It might mean they were too early to tighten," said Vincent Reinhart, chief economist at Mellon.

It also may end the Fed's brief flirtation with a benchmark interest rate that had, for the first time in roughly a decade, actually risen above the rate of inflation and become positive on a "real," or inflation-adjusted, basis.

The Fed reached that milestone in September when its benchmark policy rate was raised to a range of between 2% and 2.25%, with inflation lodged at around 2%.

It offered the prospect of an economy strong enough to support above-zero real rates, and a return to more normal times when routine savings accounts might produce a positive real return.

But the drop in inflation since then means that the real rate has actually been rising, representing tighter financial conditions than the Fed intended.

The Fed lost ground on another front when policymakers marked down their estimate of the long-run federal funds rate, a rough proxy for the neutral rate that neither encourages nor discourages investment and spending decisions, from 2.8% to 2.5%.

The combined markdowns to those two key metrics meant, in effect, that Fed officials viewed their current policy as tighter than previously thought, and by roughly enough to be offset by a rate reduction of half a percentage point.

Although the focus on Wednesday may have been on trade and global risks, the coming rate cuts may also just be the Fed's way of adjusting policy without signaling an economic slowdown, Reinhart said.

"If (Powell) can pitch this as realigning nominal rates in light of the low inflation environment, it is much less of a shock," Reinhart said.

(Reporting by Howard Schneider; Editing by Paul Simao)

By Howard Schneider