Drop in inflation will keep Fed on hold for now

The unexpected decline in core inflation over recent months is only partly due to transient factors and suggests that, after raising rates twice in the first half of the year, the Fed will hike rates just once more this year. The Fed had argued that one-off factors, including the big drop in wireless phone plan prices and slower drug price inflation, would drop out of the annual comparison next year and cause inflation to rebound. But alternative measures highlight that the slowdown in inflation has been more broad-based. Even so, the real economy remains in fairly good shape. GDP growth looks to have rebounded in the second quarter and the survey evidence is consistent with a continued acceleration. In those circumstances, the unemployment rate is likely to fall to 4% by year-end, putting some upward pressure on wage growth. Together with a modest package of tax cuts from Congress, we think this will prompt the Fed to raise rates four times next year, taking the fed funds rate to 2.25-2.50% by end-2018.