One or more rate hikes by the Federal Reserve in 2016 remains a real possibility. Why would the Fed consider such a policy action given the recent collapse in inflation expectations?

Over the past couple of months many analysts and the futures markets have assigned a rather high probability to the so-called “one and done” – no change in policy in 2016. Indeed, here is what we’ve heard recently from St. Louis Fed President James Bullard:

Reuters: – The Federal Reserve must act to stop inflation expectations from getting too low, St. Louis Fed President James Bullard said on Wednesday, reiterating his concerns about continuing to raise interest rates.

The U.S. central bank cannot let low inflation expectations “get out of hand,” he told a dinner of bond traders here, adding he “can’t stomach” currently low readings. “It’s just that they’ve fallen so far that it’s got to be a concern.”

Source: @auaurelija

However a number of researches have suggested that with a relatively stable core inflation in the United States, oil prices would need to collapse to levels that are neither consistent with today’s forward curve nor sustainable. Therefore, these studies argue, the current market-based inflation expectations are simply irrational.

1. Here is the latest analysis from Goldman Sachs.

Source: Goldman Sachs

2. Also, a study from the St. Louis Fed shows a similar result.

Source: St. Louis Fed

Moreover, US inflation measures are starting to stir – especially in the services sector. This is something the FOMC is not going to ignore. Below we have some of the recent reports.

1. The core PCE inflation, the Fed’s primary inflation measure, exceeded consensus on Friday.

2. US CPI measures, both the headline and the core, also came in above expectations.

 

Source: Investing.com

3. As an example of where some of this inflation is coming from, shown below is the medical care CPI. It has been subdued last year but is now is waking up again.

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