The Federal Reserve left interest rates unchanged yesterday, but the central bank continued to signal that a hike at next month’s policy meeting remains a possibility. The reasoning is that the US economy continues to post solid growth. But a closer look at the numbers suggests that the pace of expansion is slowing. There are also hints that the reflation trend over the past year or so may be rolling over. If so, the case could be weakening for more policy tightening.

The alternative view is that inflation is stable and is set to hold at or near the Fed’s 2% target. Exhibit A for this narrative: the core rate of PCE inflation, the Fed’s preferred measure of pricing pressure, increased 2.0% for the year through September.

Meanwhile, last week’s payrolls report for October revealed that wage growth accelerated to a 3.1% annual increase — the strongest jump in nearly a decade.

Inflation, it seems, is poised to hold at the Fed’s target and perhaps edge higher. Why, then, is Treasury market’s implied inflation forecast drifting lower? Consider the spread for the nominal 5-year rat less its inflation-indexed counterpart. After spending most of the year above the 2% mark, this widely followed estimate of future inflation has eased in recent weeks to around 1.9%.

The slide in the Treasury’s estimate could be noise, of course. The government bond market is, at best, a crude measure of future inflation – and a hopelessly flawed one, by some accounts. But if this measure of pricing pressure continues to slide the trend will raise more questions about the Fed’s plans for extending its rate hike policy.

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Note, too, that current GDP estimates for the fourth quarter call for another round of deceleration in economic output. As outlined earlier this week, The Capital Spectator’s median estimate for Q4 growth is 2.9% for GDP (seasonally adjusted annual rate) via several sources. If accurate, the expansion is on track track for a second consecutive quarterly downshift, which would pare economic growth to the softest pace since the 2.2% rise in this year’s Q1.

Yesterday’s Fed statement noted that “economic activity has been rising at a strong rate” but “business fixed investment has moderated from its rapid pace earlier in the year.”

Michelle Meyer, US economist at Bank of America Merrill Lynch, wrote in a research note that the central bank left out some key points about the economy in the statement:  “there was no mention of the softer housing data. Moreover, there was no mention of the sell-off in the stock market in October which implies that Fed officials were largely willing to shrug it off.”

That leaves the market to focus on the incoming inflation data, starting with today’s numbers on producer prices and next week’s release of consumer inflation for October. Economists are expecting that a roughly 2% trend will remain in force.

Even if there are no downside surprises lurking for the hard numbers on inflation, the debate about the Fed’s plans for more rate hikes will face more pushback. Some analysts argue that the central bank’s mission has been accomplished – inflation is holding at the 2% target and economic growth remains healthy.

For now, Fed funds futures are projecting a high probability (76%) of a 25-basis-point rate hike at next month’s FOMC meeting that would lift the target rate to a 2.25%-to-2.50% range, based on CME data.

The question is whether the Treasury market will continue to price in lower-than-expected inflation? That seems likely if the projections hold for slower Q4 growth.

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