Inflation may seem to be the ultimate dichotomy; a path toward two contradictory and conflicting events – rising prices and economic vitality. Yes, cheering for higher prices appears inconsistent with economic prosperity. However, in moderation, inflation simply represents a driving demand for goods and services. This demand propels the economy forward. Given this synergy between prices and economic growth, it’s understandable why low inflation is at the top of the Federal Reserve’s list of concerns.
The Fed serves as America’s central bank, promoting the health of the U.S. economy and the stability of our financial system. Driving the nation’s monetary policy is one of its core missions. Through management of short-term interest rates and the availability and cost of credit, it seeks to manipulate spending, investment, employment and inflation to foster economic growth.
The next scheduled meeting for the Fed is Sept. 19-20. The expectation is that there will not be an increase in the fed funds rate, which serves as the benchmark for short-term rates. Any potential rate hike would likely occur at its last meeting in December. Instead, the financial markets will dissect the latest commentary from Fed officials on the state of the U.S. economy, and perhaps its greatest concern – a persistent lack of inflation.
The Fed’s preferred measure for tracking inflation is the core Personal Consumption Expenditures index, or PCE. This index measures the annualized change in prices for consumer goods and services, excluding the more volatile and seasonal food and energy prices. The Fed’s target rate for core PCE is 2 percent. Unfortunately, inflation has not reached 2 percent since April 2012.
It was thought that 2017 would be the break-out year for rising prices. Instead, inflation has been in a relative freefall, plummeting from 1.89 percent in January to its current 2017 low of 1.41 percent. In June, the Fed was forced to lower its 2017 inflation projections to just 1.7 percent. Its timeline for 2.0 percent inflation has also been pushed to 2019.
There is general agreement among Fed officials that low inflation is transitory. However, there is less consensus on what is causing low inflation or how long it will last. And therein lies the puzzle that vexes the Fed; trying to explain away a lack of inflation with so many tailwinds at the economy’s back.
The U.S. labor market remains robust with the national unemployment rate at 4.4 percent, near a 16-year low. The economy continues to grow at a moderate, yet stable pace. Economic growth jumped to 3 percent in the second quarter, its strongest rate in more than two years. Consumer spending, the cornerstone of U.S. economic growth, rebounded while business investment surged in the first half of the year. All good news, yet inflation continues to decline.
The Fed will have more than three months of economic data to assess the inflationary landscape before its final calendar year meeting in December. Given the current inflationary environment, it can well afford to be patient. Yet the Fed remains confident economic conditions should evolve to warrant future rate hikes. In reality, their internal discussions are a matter of when, not if, the next hike will be.
The Fed’s conviction for its rate hike agenda may soon come to a crossroad. At its September meeting, the Fed is expected to announce plans to unwind its massive $4.5 trillion balance sheet of bonds and securities it bought in response to the 2007-2009 recession. The impact should be gradually absorbed. Nonetheless, the resulting increase in long-term interest rates and cost of debt will have a constrictive effect on economic growth. Coupled with the Fed’s desire to raise the short-term fed funds rate, the potential detriment to the U.S. economy is clear.
The financial markets have yet to share the Fed’s optimism on the return of inflation and the future of further interest rate hikes. In fact, the current implied probability of a December rate hike is only 41 percent. The Fed’s disconnect with the financial markets is not unusual. Unfortunately, it does highlight a credibility gap in recent years for the Fed to accurately predict inflationary outcomes.
With the stock markets extending their gains to record highs, it seems the financial markets have confidence the Fed can be flexible enough in its rate hike agenda. Let’s hope that confidence proves correct.