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The Federal Reserve Took down Its Inflation Forecast

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Jan. 8 2016, Updated 10:06 a.m. ET

The Fed uses a different inflation measure

The Fed prefers to use the PCE (personal consumption expenditure) index over the CPI (consumer price index) to guide its decisions, as the former measures inflation.

There are a few differences between the two indexes. The PCE index is updated more often, and it takes other factors into account such as employer expenditures on healthcare and substitution between goods. The CPI is based on what people say they’re buying, and it isn’t adjusted as often.

As a general rule, the CPI overemphasizes housing, while the PCE index overemphasizes healthcare. There just isn’t a perfect inflation indicator.

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The Fed keeps taking down its inflation forecast

In September 2013, the Fed forecast that 2015 inflation would be 1.6%–2%. It ended up coming in at 0.4%. The Fed had been consistently too high on its inflation projections.

At the December meeting, the Fed took down its 2016 inflation forecast from 1.7% to 1.6%. The stronger dollar is affecting commodity prices and imports, and that’s keeping a lid on inflation. In all reality, we probably won’t see much inflation until wages pick up. The latest couple of jobs reports show that wages are rising modestly.

Inflation has consistently run below the Fed’s 2% target. However, the Fed views the effects of the dollar and low commodity prices as transitory. Of course, if the Chinese economy implodes, inflation will probably remain muted.

Implications for mortgage REITs

For REITs like Annaly Capital Management (NLY), American Capital Agency (AGNC), MFA Financial (MFA), Hatteras Financial (HTS), and Two Harbors Investment (TWO), low inflation means the Fed has the freedom to keep interest rates low. This gives wiggle room to raise rates in a gradual fashion.

Investors interested in making directional bets on interest rates can consider the iShares 20+ Year Treasury Bond ETF (TLT). Investors interested in trading in the mortgage REIT sector via an ETF can look at the iShares Mortgage Real Estate Capped ETF (REM).

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