Fed still to convince the markets of further rate hikes

Fed officials continue to anticipate one more rate hike in the second half of this year, but markets are not even convinced that the Fed will hike rates again within the next two years. The Fed has brought some of the market scepticism on itself, by repeatedly failing to follow through on planned rate increases in recent years. The decline in Treasury yields also presumably reflects growing fears that the window to pass tax cuts is rapidly closing. The mid-term elections scheduled for late next year mean that if the tax cuts aren’t passed by early next year, they might not happen at all. The bond market is also probably more focused on the undershoot in core inflation than the recent decline in the unemployment rate. But we would stress that the Fed follows a dual mandate and, although Yellen noted this week that the so-called Phillips curve had flattened, she evidently still expects that lower labour market slack will eventually push wage growth and price inflation higher. We don’t expect core inflation to fall any further, but there is a risk that the unemployment rate will drop to 4% soon.