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Why Inflation Remains Too Low for the Fed

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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 takes other factors into account such as employer expenditures on healthcare and substitution between goods. CPI is based on what people say they’re buying, and it isn’t adjusted as often.

As a general rule, 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

The Fed has been consistently high in its inflation forecasts. For example, in September 2013, the Fed forecast that 2015 inflation would be 1.6%–2%. It ended up coming in at 0.4%.

At the March 2016 FOMC meeting, the Fed took down its 2016 inflation forecast from 1.6% to 1.2%. The stronger dollar is affecting commodity prices and imports, and that’s keeping a lid on inflation. In reality, we probably won’t see much inflation until wages pick up. The latest two jobs reports show that wages are rising modestly.

At the April meeting, both the staff and the FOMC members noted that inflation was still running below the Fed’s 2% target. However, some of this is due to falling commodity prices. The Fed views the effects of the dollar and low commodity prices as transitory.

Implications for mortgage REITs

For REITs such as 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. Low inflation gives the Fed some 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 through an ETF can look at the iShares Mortgage Real Estate Capped ETF (REM).

In the next part, we’ll see what the FOMC said about credit conditions.

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