Trimmed Inflation indicates that Fed will hike rates in December…

When the US Fed decided to maintain status quo on rates in September, the standard refrain was that the Fed may choose to put off rate hikes till 2016. Let us first look at the 3 components that the US Fed is closely watching. First is the GDP growth, which has been growing and showing signs of getting closer to the 3.5-4% mark. Secondly, the employment figures are also encouraging with the unemployment rate at a low of 5%, which is as close to full employment as it could be. The only missing variable is inflation which is way below the targeted 2%. The Fed had earlier indicated that it would be ripe for a rate hike only when inflation got back to the 2% mark. With the global crash in oil prices and all other industrial commodities getting cheaper, inflation was never going to reach 2%. If that is what you believe, then we may have to do a rethink…

Time to look at Trimmed Inflation…

The Dallas Fed uses a different measure called the Trimmed Inflation. In simple terms, Trimmed Inflation is nothing but a calculation of inflation after removing the outliers. As the term suggests, outliers are the kind of statistical noise that lie far away from the mean and do not reflect the normal circumstance inflation. While calculating trimmed inflation, such non-sustainable outliers have been eliminated and the graph has been re-plotted. Let us look at the outcome!

Over the last 8-9 months, the normal inflation has been in the range of 0.2-0.3%.  If you look at the chart of normal inflation in the US, the sharp fall from the 1.6% level to the 0.2% level happened during the second half of 2014. This was largely due to the sharp fall in the price of crude oil globally. That is where trimmed inflation becomes relevant. What trimmed inflation does is to remove such sudden outliers in data so that a more smoothed inflation chart can be obtained. So what does the Trimmed Inflation Chart look like?

Interestingly, when trimmed inflation is considered and the chart is plotted, the inflation is closer to the range of 1.6-1.7%. This is probably a more realistic picture of long term sustainable inflation. Remember, crude prices go through cycles and in the past, sharp corrections in price of crude oil have been followed by much more violent bounce back in crude oil prices. Hence calculating inflation purely based on absolute inflation values can be misleading. That is why Trimmed inflation is a lot more representative as a measure of sustainable inflation.

What does this mean for Fed Rate Decision…?

If one goes by Trimmed Inflation, then the Fed is much closer to its 2% inflation target than what is made out to be. The US has already achieved the sustainable GDP growth to justify its rate hike. At 5% unemployment, the US economy is as close to full employment as is humanely possible. The only missing link in the entire story was inflation at 2%. If one looks at Trimmed Inflation instead of normal inflation, then the sustainable level of inflation is at 1.6-1.8% and not at 0.2-0.3% as is being made out to be by the raw data.

The moral of the story is that the US may actually have all the data points required to undertake its first rate hike since 2006, when it meets once again in December 2015. Whether Janet Yellen really wants to set the cat among the pigeons by hiking the Fed rates and temporarily spooking global markets; is a different story altogether!

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