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Must-know outlooks from the December FOMC meeting

Part 4
Must-know outlooks from the December FOMC meeting (Part 4 of 4)

Why did the Fed take down its 2014 inflation forecast… again?

At the December FOMC meeting, the Fed released its economic forecasts

Usually at the March, June, September, and December FOMC (Federal Open Market Committee) meetings, the Fed releases its economic forecast for the current year and the upcoming two years. One of the nice things about this is that you can see how its forecast has changed over time. In this part of this series, we’ll look at its inflation forecast for 2013, 2014, 2015, and 2016, and also at how its forecast for 2014 inflation has changed over the past few meetings.

Fed 2014 Inflation ForecastEnlarge Graph

The Fed uses a different inflation measure

The Fed prefers to use personal consumption expenditures, or PCE, as its measure of inflation over the consumer price index, which is more familiar to most people. There are a few differences between the two—mainly in that the personal consumption expenditure index is updated more frequently and takes into account things like employer expenditures on healthcare and substitution between goods. The consumer price index, or CPI, is based on what people say they’re buying, and it’s adjusted less frequently. As a general rule, the CPI overemphasizes housing while the PCE overemphasizes healthcare. There just isn’t a perfect inflation indicator.

The Fed takes down its forecast for 2014 inflation

In December of 2012, the Fed was forecasting that inflation would remain around 1.6% to 2.0%. By the December 2013 meeting, it had taken down that number to between 1.4% and 1.6%. It’s important to understand the Fed’s mandate regarding inflation. Its job isn’t to minimize inflation, but to promote price stability. The Fed has a dual mandate—to manage inflation and to stimulate the economy in order to promote full employment. The Fed fears deflation, and given that we’re at the lower bound for interest rates, a decrease in inflation actually increases real interest rates. So the Fed will try to keep inflation around 2%. As a practical matter, for the average American, 3% inflation with 3% wage growth feels much more comfortable than no inflation and no wage growth.

Implications for mortgage REITs

For REITs like Annaly (NLY), American Capital Agency (AGNC), MFA Financial (MFA), Hatteras (HTS), and Two Harbors (TWO), low inflation means low interest rates for the foreseeable future. While the Fed may decide to remove accommodation through decreasing asset purchases, it will probably maintain the Fed funds rate at 25 basis points for the next few years. This means that while the yield curve may steepen, it isn’t going to do a parallel shift for quite some time. This puts a limit on how much interest rate risk the REITs actually have.

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