Federal Reserve officials are increasingly concerned
that low inflation may be more persistent than “transitory,”
and that could slow the pace of interest rate hikes.
A flat yield curve, where long-term interest rates are
unusually close to short-term rates, is a bad sign for the
economy and is also a reason for Fed officials not to raise
The Fed’s forecasts still point to three interest-rate
increases this year, but doubts from investors could lead to
market turbulence later in the year.
Federal Reserve officials are becoming increasingly conflicted
about whether to keep raising interest rates. That could spell
trouble for a breathless stock market rally that many investors
feel has already entered bubble territory.
At the center of the debate is a chronically-low inflation rate
that signals the US economy and the job market are still
operating below their full potential, despite the unemployment
rate sitting at a 17-year
low of 4.1%.
One of the Fed’s preferred inflation measures stands at just
1.5%, well short of the central bank’s 2% target, and there are
fears that weak inflation expectations portend a further period
of relative softness.
“With core inflation readings having moved down this year
and remaining well below 2%, some participants observed that
there was a possibility that inflation might stay below the
objective for longer than they currently expected,” the minutes
For now, the central bank’s hesitance is not a major cause
for concern as investors bid the US stock market to ever loftier
highs. But if the rally begins to peter out later in the year as
some expect, then a gap between market expectations of Fed action
and the Fed’s own forecasts could increase market
Low inflation may sound like a good thing, but when it’s
pervasive and persistent it can signal weak wage growth and a
lack of demand for labor. Fed officials have long assumed a
falling jobless rate would lead to stronger inflation pressures,
but have consistently been disappointed.
“There is still confusion and disagreement about
inflation,” said Ward McCarthy, chief financial economist at
Jefferies, in a research note.
“Policymakers also set the stage for different approach to
addressing the inflation objective and how to decide if this
objective has been met,” he added. “The hawks continue to be rate
normalization gradualists. The doves are perpetual pessimists who
view rate normalization as an anathema, and will grab any
available straw to slow the process.”
That raises considerable uncertainty around the Fed’s own
projections for around three interest rate increases this
Bend it like the yield curve
A second key dilemma is also giving some policymakers pause
about further interest rate rises: the unusually narrow gap
between short-term borrowing costs and their long-term
counterparts, known in market parlance as a flat yield curve.
When long rates actually slip below short-term ones, the yield
curve is described as “inverted,” something that usually
precedes a recession.
“This is a massive curve flattening and if the Fed
continues to raise the policy rate” the curve may well invert,
founding managing partner of Westwood
Capital, LLC, told Business Insider.
“In the past
that’s always signaled a recession.”
The Fed has raised in
terest rates five times
since December 2015 to the current range of 1.25% to 1.5%. The
gap between two-year Treasury notes and those on ten-year notes
is currently around just a half percentage point, suggesting
investors expect neither stronger growth nor accelerating
investment returns in the foreseeable future.
The minutes said “several participants thought that it
would be important to continue to monitor the slope of the yield
In addition, “some expressed concern that a possible future
inversion of the yield curve … could portend an economic
slowdown, noting that inversions have preceded recessions over
the past several decades, or that a protracted yield curve
inversion could adversely affect the financial condition of banks
and other financial institutions and pose risks to financial
Roberto Perli, a former Fed economist who is now co-founder
and partner of Cornerstone Macro, wrote in a research note that
“‘several’ is not a majority, but is also more than the few FOMC
members we heard expressing concerns about a flat curve publicly
in recent months.
“Since the curve is likely to continue to flatten, it could
become one more issue that could prevent the FOMC from reaching
the 2.75% terminal rate it currently projects,” he said.
Both St. Louis Fed President James Bullard and Philadelphia
Fed President Patrick Harker expressed concern about the flat
curve and the prospect of an inversion in interviews late last
“We should just [maintain] a slow removal of accommodation
to minimize the risk that [a curve inversion] would happen,”
Harker said. “I
want to make sure we don’t exacerbate that problem.“