Global Economic Perspectives:The great US inflation debate,Waiting for the whites of inflation's eyes?

In the wake of a relatively hawkish statement following the SeptemberFOMC meeting, serious doubts nevertheless persist among many of ourcolleagues in the market as to whether the Fed will ever raise rates again.

    Despite increasingly clear signals from the Fed about its intentions for arate hike later this year, market expectations on December remain miredin the neighborhood of 50/50. Our objective in this week's GEP is to sortthrough the disparate data and Fedspeak about one crucial area of debatefor the next rate hike: the inflation outlook.

    Based on our findings about the current state of and prospects forinflation, we conclude that the market is wrong-footed to assume thatthe Fed will always back off in the face of potential market tantrums. Asthe labor market continues to tighten and inflation pressures build, slowlybut inexorably, the Fed will have less and less room to maneuver aroundmarket squalls. Fed folks are also increasingly mindful that the longer theyput off gradual action, the greater the potential for disruptive financialreactions when they eventually do have to move. So the case for movingby December is a stronger one than the market is currently pricing.

    We provide a summary of the views of the hawks and doves on keyquestions related to inflation: the interpretation of recent data for priceand wage inflation, inflation expectations and the labor market; thevalidity of a Phillips curve framework – which relies on an inverserelationship between economic slack and inflation – for modeling andprojecting future inflation; the magnitude and persistence of the role ofinternational factors in weighing on inflation; and how they interpret theFed's 2% inflation target. We then render our views about which side'sinterpretations of the key issues are most compelling.

    Finally, we conclude by presenting forecasts from our inflation model.

    While core PCE inflation is expected to remain near current levels throughthe first half of 2017, it then follows a path that is broadly consistentwith the Fed's median projections, with inflation grinding gradually highertoward 2% in 2018 and 2019. Alternative scenarios show that thereis considerable uncertainty around these projections, with reasonableassumptions about the model's inputs leading to a range of forecasts fromabout 1.5% to 2.5% by end-2019.