Fed conflicted by tepid U.S. inflation, global economic rebound

[September 20, 2017]  By Howard Schneider and Ann Saphir

WASHINGTON (Reuters) - Caught between a lull in U.S. inflation and a stronger global economy, the Federal Reserve is expected on Wednesday to signal whether it will raise interest rates for a third time this year or back off until prices rise more briskly.

The U.S. central bank's description of inflation in its policy statement as well as fresh economic forecasts from individual policymakers will be the main focus for financial markets amid a recent spate of lukewarm domestic data.

The policy statement and projections are due to be released at 2 p.m. EDT (1800 GMT). Fed Chair Janet Yellen will hold a press conference half an hour later.

The Fed also is likely to announce a scheduled reduction of its approximately $4.2 trillion in holdings of bonds and mortgage-backed securities, most of it accumulated in response to the 2007-2009 financial crisis and recession.

That plan, anticipated by markets and not expected to have much immediate impact, will limit the amount of maturing bonds used each month to purchase new ones. The initial cut in reinvestment will be $10 billion per month, probably beginning in October.

Analysts and investors, however, say they will look more intently at policymakers' forecasts for the end-of-year federal funds rate as an indication of whether a quarter-point increase widely expected in December is likely to occur.

Minutes from recent Fed meetings have shown a growing split, with some policymakers saying there is no urgency to raise rates after a drop in inflation, and others arguing the U.S. economy is strong enough to continue "normalizing" monetary policy.

The Fed's preferred measure of inflation was down to 1.4 percent on an annualized basis as of July, well short of its medium-term 2 percent target.

"Relative to the June forecasts there may be more participants anticipating no more hikes this year, but we don't think so many will switch to this view as to bring down the median," said Michael Feroli, chief U.S. economist at JP Morgan.

That would require five of the 16 Fed officials participating in this week's two-day meeting to shift their rate projections lower to change a median that was 1.375 percent as of June, a quarter point above the current target of around 1.125 percent.

Economists and investors are divided over the likely outcome as well, with different analyses of the market price for federal funds futures contracts putting the likelihood of a rate hike in December as low as 43 percent and as high as 56 percent.

A police officer keeps watch in front of the U.S. Federal Reserve building in Washington, DC, U.S. on October 12, 2016. REUTERS/Kevin Lamarque/File Photo

'REAL DESIRE'

Although the Fed has been troubled by the drop in U.S. inflation, Yellen and other officials have attributed it to short-term factors, such as changes in cellphone plan pricing, that should diminish in the coming months.

Financial conditions also remain loose across the United States, and long-term interest rates have fallen recently, factors that strengthen the argument that another rate hike would not slow the economy.

A higher target rate, meanwhile, would push the Fed further from the zero percent lower bound it has been trying to escape after a decade nurturing the U.S. economy into a post-crisis recovery.

Anyone ruling out a December rate increase "is mispricing the real desire on the part of the Fed to continue" normalizing monetary policy despite the dip in inflation, said Jason Celente, senior portfolio manager at Insight Investment.

"As long as employment remains robust and conditions don't deteriorate there is scope and willingness to go ahead," he said.

But with its balance sheet reduction plan operating in the background, the Fed will be putting upward pressure on borrowing costs each month regardless of what it does with its benchmark interest rate.

Meanwhile, other central banks, including in the economically resurgent euro zone, may begin tightening policy, leading to more restrictive financial conditions globally. A looming battle at the end of the year over the U.S. government's debt limit and spending also could further disrupt markets.

Scott Anderson, an economist at Bank of the West in San Francisco, believes the Fed will ultimately align with markets that generally expect a slower pace of rate increases.

"Rate hikes with quantitative tightening will be a lot of tightening for the markets to digest," Anderson said. "They might have to scale back on how aggressively they raise rates over the next couple of years."

(Reporting by Howard Schneider; Editing by Paul Simao)

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