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Low Inflation Changes Rate-Hike Outlook

Fixed-income economists are now predicting the Federal Reserve will not hike interest rates as severely as expected given the Consumer Price Index (CPI) figures for August, which were released last week.

Fixed-income economists are now predicting the Federal Reserve will not hike interest rates as severely as expected given the Consumer Price Index (CPI) figures for August, which were released last week. The softer-than-expected numbers spurred a bond market rally of eight to 10 basis points across the yield curve.

Inflation was widely expected to rise by 0.2%. However, inflation in August rose only 0.1%, making it the third month in a row in which inflation inched 10 basis points higher.

The soft trend has economists revising downward their predictions for an end-of-year Fed Fund rate from 2.25% to 2%. While the Fed is widely expected to raise interest rates by 25bps at its next meeting on Sept. 21, the Fed may now hold off during the Nov. 10 meeting, said Ethan Harris, chief U.S. economist and managing director of Lehman Brothers. "Inflation has receded to being a non-issue from the Fed's perspective," Harris said. "The smart money was betting on a serious inflation problem and an aggressive Fed but the data doesn't support that."

Prior to the report, the yield on 10-year Treasuries was widely expected to hit 5% by the end of the year. Based on the inflation number, Harris now predicts a yield of 4.4%. And if the Fed decides not to raise rates in November, yields may even dip temporarily below 4%, he said.

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