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Investors temper expectations for three Fed rate rises in 2017

Market expectations for the Federal Reserve to raise interest rates three times this year have dropped below one-in-three, the lowest level since mid-May, after gloomy data ignited jitters ahead of the central bank’s policy decision later on Wednesday.

The odds of a trio of Fed rate increases this year fell to 31.7 per cent on Wednesday, from 50.6 per cent the previous day, according to Bloomberg data on federal funds futures that traders use to speculate on monetary policy. The probability has not been that low since May 17.

Data pointing to a slowdown in consumer price growth sparked speculation that the Fed will use stronger language later on Wednesday to describe the underwhelming inflation readings that have persisted even as the labour market has continued to tighten.

“Given further evidence of a more persistent core inflation shortfall, we now expect this afternoon’s FOMC statement to include a stronger acknowledgement of the recent soft inflation data,” Goldman Sachs economists Spencer Hill and Daan Struyven said.

The Fed is expected to push its benchmark lending rate higher by a quarter-point, in the second rate increase this year. It has been predicting a total of three rate increases for 2017, but economists have questioned whether that will come to fruition since inflation has been running under the Fed’s 2 per cent target.

“Another surprisingly weak inflation report, raising questions for the path of Fed policy after today’s likely hike and creating a rising dilemma as misses on either side of the dual mandate increase in opposite directions,” noted Morgan Stanley economist Ted Wieseman.

“Even as the unemployment rate keeps hitting new lows below most estimates of a sustainable level and financial stability concerns mount … continued Fed tightening risks driving further declines in inflation expectations and making ever achieving the inflation target more difficult”.

The reaction played out across financial markets on Wednesday, with Treasury yields and the dollar falling markedly. The 10-year yield was off 0.1 percentage point (10 basis points) at 2.11 per cent, with the dollar sinking almost 1 per cent against the Japanese yen.

The five-year inflation break-even rate — a closely watched market-based measure of inflation expectations — also receded, recently sinking 7.6 bps to 1.61 per cent. That suggests investors are not expecting inflation to reach the Fed’s target over the next half-decade.