Commentary for Friday: We learned yesterday that the core CPI increased twotenths in May. As a result, the year-over-year growth rate ticked up a tenth to2.2%: This rate has been in excess of 2% for seven consecutive months.However, other measures of inflation continue to underwhelm. Year-over-yearcore PCE inflation, the Fed’s favored metric of price pressures, is running atjust 1.6%. Moreover, as shown in the chart below, both the Fed’s five-yearforward breakeven inflation rate and University of Michigan long-term inflationexpectations have recently moved substantially downward. In fact, thepreliminary June reading of the latter was an all-time low (2.3%). The decreasein inflation expectations is particularly noteworthy because it cannot beblamed on the possibly transitory effect of energy prices: Gasoline prices areup almost 30% since their trough in February.

　　Weak realized inflation has been an important reason why the Fed has beenhesitant to raise rates despite a tightening labor market. Now, although theformer has moved slightly upward, the FOMC has become concerned that thedecline in “market-based measures of inflation compensation” brings intoquestion the durability of this improvement. Recall that Fed Chair Yellen statedlast week that the deterioration in survey- and market-based measures ofinflation expectations has garnered her “close attention”, and that “if inflationexpectations really are moving lower, that could call into question whetherinflation will move back to 2 percent as quickly as [she expects].”The median FOMC forecasts for core PCE inflation are 1.7% for yearend 2016and 1.9% for yearend 2017. Unlike the Fed, however, we do not expectinflation to move toward the 2% target in the near term. Instead, we forecastthat it will decline slightly to 1.5% by the end of this year. This is becausehousing and healthcare inflation, the two largest components of the core PCE,appear to be stabilizing, while core goods inflation should continue to languisha bit longer in lagged response to previous dollar appreciation.

　　To be sure, recent labor market weakness will remain the Fed’s primaryconcern. However, depressed inflation expectations will reinforce the Fed’scautiousness. Therefore, we continue to forecast that the Fed will raise ratesjust once this year, most likely in December, with the risk that rate hikes willbe delayed until next year. The FOMC seems to be coming around to this view:Whereas at the March meeting only one participant was forecasting a singlerate hike this year, six of the 17 participants now expect just one rate increasein 2016.