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Low inflation is troubling backdrop to Fed rate decision

US inflation has again undershot Wall Street expectations, providing a troubling backdrop to Wednesday’s Federal Reserve rate-setting meeting.

The year-on-year rate of consumer price inflation, stripping out fuel and food, fell to 1.7 per cent in May, its lowest since 2015, and below expectations of a 1.9 per cent rise. The index was up 0.1 per cent on the previous month, according to the Bureau of Labor Statistics. Separate figures showed a 0.3 per cent drop in retail sales, defying predictions of a flat reading. 

The data come just hours before the Federal Reserve is predicted by economists to lift its target range for the federal funds rate by another quarter point. A further move would mark the fourth increase since its rate-raising cycle started in late 2015. 

The figures will add to pressure on Janet Yellen, the Fed chair, to clarify why the central bank is planning rate increases when inflation readings are so soggy and growth has failed to take off. Since its last move in March the Fed has watched a diverging picture of a strengthening jobs market sending the unemployment rate to just 4.3 per cent, alongside poorer-than-expected price growth. 

The Fed has repeatedly said weak inflation numbers are likely to be “transitory”, yet disappointing data are becoming an established pattern. The numbers injected some doubt into markets about the outcome of Wednesday’s meeting. The euro jumped 0.4 per cent against the dollar after the news, with the pound up 0.2 per cent. The dollar was off 0.4 per cent against the Japanese yen. 

The central bank has been assuming that the steadily tightening labour market will eventually start delivering higher wages growth and inflation, helping justify plans not only for higher short-term rates but for reducing the size of its balance sheet. However, the recent spate of weak numbers could impact on Fed policymakers’ forecasts for the degree of further tightening in the coming years. 

Already some policymakers’ outlooks could be affected by the dimming prospects for a near-term fiscal stimulus by Congress, as lawmakers struggle to make progress on attempts at a tax-cutting package or infrastructure spending. 

Gus Faucher, chief economist at PNC Financial Services Group, said: “Inflationary pressures are generally soft right now. Despite an unemployment rate of 4.3 per cent in May, wage pressures remain muted. And excess capacity throughout much of the economy continues to limit firms’ pricing power.” 

He added, however, that the Federal Open Market Committee was still likely to raise the federal funds rate by a quarter of a percentage point, to a range of 1 to 1.25 per cent.

“The slowing in inflation is likely transitory, and given the tight labour market, the generally strengthening economy and an expected stabilisation in energy prices, inflation should gradually pick up over the rest of 2017 as wage growth accelerates.”