Is the Fed the victim of its own success?

"It is worth remembering that it can take 18 to 24 months for a monetary policy action to have its full effect on inflation. This means that central banks must target future inflation by anticipating future deviations from target."

These were the words of Bank of Canada (BOC) governor Stephen Poloz that helped justify the Canadian central bank's decision to lift interest rates by 25 basis points to 0.75% on 12 July - making it the first developed country central bank to follow the Fed into policy normalisation.

That's fine and dandy. Everyone knows that the transmission mechanism of monetary policy operates with a lag.

I discovered from my earlier research that it is shorter for the US - around 12 to 18 months. This perhaps explains why the Fed became the first mover. More on this later.

However, the latest update on US consumer prices showed that headline inflation decelerated to 1.6% in the year to June from 1.9% in May - the lowest since October 2016 and the fourth consecutive month of slowing rates of growth in prices since 2.8% in February this year. So too with core inflation (reported as steady at 1.7%), it eased to 1.71% in June from 1.74% in May - the slowest since February 2015 and the fifth month of sequential deceleration since January's 2.3 year-on-year rate.

Suddenly, low inflation is looking less "transitory" as Janet Yellen deems in the latest Fed statement and in her recent testimonies. It's also looking less likely due to what Yellen termed as "idiosyncratic factors, including sharp declines in prices of wireless telephone services and prescription drugs..."

Inflation isn't lifting despite the US unemployment rate (4.4% in June) falling below estimates of NAIRU (4.9% OECD; 4.5% Oxford Economics) over the past months. It could be because of wages' lagged response. It could also be because the NAIRU for the US is now lower.

But whatever it is US inflation remains low and softening, and the easing trend in US retail sales growth offers no support.

US retail sales fell by a lower than expected 0.2% in the month of June following a 0.1% decline in the previous month. Core retail spending (ex-autos) decreased by 0.2% last month after posting a 0.3% fall in the month of May. Year-on-year, headline retail sales growth slowed 2.8% in June from 4.1% in the previous month while core retail sales growth eased to 2.4% from 3.7%.

This could be due to lowered inflation expectations. Why spend now when prices aren't rising (even softening) anyway? The Conference Board's consumer sentiment survey showed that "12 months ahead" inflation expectations fell to a reading of 4.6% in June from 4.7% in the previous month and this year's high of 4.9% recorded in January. This is the same message by inflation expectations measured using the yield differential between the nominal 10-year Treasuries and the Treasury Inflation-Protected Securities (TIPS) of the same maturity. The yield differential has fallen to 1.75% at the close of last Friday's trading - down from this year's high of 2.07% posted in January.

This could also be due to higher real US interest rates. Relatively higher bond yields plus lower inflation lifts real interest rates - measured by the difference between the yield on 10-year US Treasuries and core inflation - even more. Real US interest rates based on this measure has risen to 0.58% in June from 0.19% in January and mostly negative throughout 2016. Proof - US consumer credit has been steadily slowing this year, down to a five-year low of 5.8% in the year to June from this year's high of 6.4%

Underlying all these is, perhaps, the Fed's success in "tapering" policy accommodation. Success, because 13 months after the Fed first raised interest rates in December 2015 (recall the 12 to 18 months lag in the transmission mechanism of US monetary policy) retail spending peaked in January 2017 - headline at 5.6% (yoy) and core at 5.4%.

So has US inflation. Headline CPI inflation peaked at 2.5% in the year to January 2017; core inflation at 2.3% in the same month.

The subsequent rate hikes in December 2016, March and June 2017 are yet to be transmitted.

Read more: FedNAIRUBank of CanadaConference BoardHeadline CPIJanet YellenStephen PolozTIPSUS Treasuries
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