Fed Faces Challenging Inflation, Market Environment

        By Michael S. Derby
        The Federal Reserve is almost universally expected to raise interest rates this year. That it will be doing so in a challenging environment is becoming ever more clear.
        Reports Tuesday from Capital Economics and TD Securities underscore the difficulties facing central bankers as they seek to raise rates off of near zero levels.
        Capital Economics said in a report that tumbling oil prices will almost certainly send headline inflation into negative territory at the start of the year, and that deflationary readings could hold sway for much of the year. They don't see this environment as deterrent to a Fed rate hike, however, because this sort of deflation is "good" and a positive for growth.
        Over the longer run, "this bout of deflation will be temporary and, since the U.S. is a net importer of oil, lower oil prices will also provide a now massive boost to the real economy. The latter explains why the Fed will still raise interest rates this year," the firm told clients.
        Capital Economics' view is widely held. That said, deflationary prices would put the central bank even farther from reaching its 2% price target, something it's failed to do for over two years. The central bank has pledged to defend its price target from both the high and low side, so it will take a nimble communications effort for the central bank to explain why it is raising rates when prices are so far short of the desired level.
        Capital Economics notes the Fed has only raised rates in a sub-2% price environment twice, and never when inflation was in negative territory, as it could well be in the middle of the year, when most believe the Fed will act.
        The price environment and worries about overseas growth are powering a drop in bond yields. While that's another plus for the economy in the form of cheaper borrowing costs, that development could also affect the Fed policy outlook. New York Fed leader William Dudley said last month the U.S. central bank is in a delicate dance with markets: If markets don't pass on the higher borrowing costs the central bank desires, Fed policy may have to become more aggressive. Likewise, if financial conditions tighten more than the Fed wants, it could call for a less aggressive campaign of rate rises.
        TD Securities' Eric Green notes Fed officials "are not tone deaf to the underlying message inherent in the move lower in yields, inflation expectations, or energy prices." He adds, "there appears to be a growing disconnect between Fed optimism on the recovery and a market sending signals consistent with 'false dawns' that peppered earlier periods in this recovery."
        He says the Fed will likely interpret low bond yields in the context of global economic anxiety, and adds officials will probably see the decline in market-based inflation expectations as directly tied to oil, and thus transient. For now, Mr. Green says the Fed will "look through" these developments absent a shift in officials' own outlook for the economy.
        (END) Dow Jones Newswires

        January 06, 2015 18:12 ET (23:12 GMT)

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