Don't Buy The Low Inflation Story

Federal Reserve Chair Jerome Powell sent investors home happy for the weekend last Friday when he outlined a fairly balanced plan of interest rate increases designed to fight inflation while avoiding throwing the economy off track. Nevertheless, some economists at the Fed itself appear to believe that the central bank may not be taking the threat of inflation seriously enough.

In his prepared remarks for his speech at the Kansas City Fed’s annual policy symposium in Jackson Hole, Wyoming, Friday, Powell indicated that he’s not overly worried about rising inflation, or at least not enough to be more aggressive about raising rates to avoid piercing a hole in the economic balloon just as it’s starting to expand.

“While inflation has recently moved up near 2%, we have seen no clear sign of an acceleration above 2%, and there does not seem to be an elevated risk of overheating,” the Fed chair said. Moreover, he said the Fed has to balance “moving too fast and needlessly shortening the expansion, versus moving too slowly and risking a destabilizing overheating. I see the current path of gradually raising interest rates as the approach to taking seriously both of these risks.”

That was enough to push the S&P 500 to its first record close since January 26 and the yield on the benchmark 10-year Treasury note to 2.81%, which is down about 20 basis points from its recent peak of 3.00% at the beginning of this month.

But a research paper written by five Fed economists argues that Powell – who is not an economist but has plenty of them on his staff – may be underestimating the threat of future inflation in light of the fact that the current low unemployment rate isn’t – at least not yet – pushing up wages and inflation. (If you don’t want to read all 40 pages of the report, which has tons of charts, graphs and mathematical equations with lots of Greek letters in them, read the summary on numbered page 1 and the Conclusion on numbered page 18). Here are the salient quotes:

“The combination of inflation recently being persistently below the FOMC’s 2% target, despite low rates of unemployment, highlights important uncertainties policymakers face about inflation dynamics on the one hand, and the natural rate of unemployment, on the other,” says the paper, which is titled, “Some Implications of Uncertainty and Misperception for Monetary Policy.”

“Uncertainties about the natural rate of unemployment have led many researchers to conclude that policymakers would be well advised to ignore potentially mismeasured labor market slack and focus almost exclusively on stabilizing inflation,” the conclusion states. “This paper has shown that because monetary policy acts with a lag, waiting for inflation to materialize before reacting is undesirable, particularly when economic conditions are such that outsized deviations of inflation from its target are a plausible outcome.” (Emphasis mine).

“While inflation appears to be insensitive to labor market slack, policy needs to take proper account of the prospects for persistently tight labor markets leading to higher inflation, or other imbalances, that could eventually endanger prospects on the employment side of their policy mandate. This paper has also shown that if the dynamics of inflation were to revert to something akin to those that prevailed in the 1970s, an inflation-averse strategy would raise the likelihood of high unemployment outcomes in the longer run, relative to a balanced approach, but without noticeable improvements in stabilizing inflation.”

In other words – if I read this correctly, since I’m not a professional economist either – that means that the Fed may be making a mistake in not taking more seriously the threat of looming wage increases and inflation brought about by a tight labor market. That could eventually mean not only more inflation but also higher unemployment that kicks in after the Fed belatedly tightens monetary policy too aggressively, creating an environment that the Fed says today it is trying to avoid with a more “balanced” approach.

I’m certainly not privy to the inflation reports the Fed gets, but the official published numbers from the government clearly show that core inflation is already well above the Fed’s 2% target. The core consumer price index for July was up 2.4% versus a year earlier, the biggest gain since the financial crisis, while the core producer price index was up 2.7%. The core personal consumption expenditures index, purportedly the Fed’s primary measure of consumer inflation, will be released on Thursday, with the consensus forecast calling for a year-on-year increase of 2.0%.

Clearly, the Fed is trying to keep the economy humming along while not sideswiping it with higher interest rates (no, I’m not suggesting that Powell is trying to make President Trump happy by keeping rates artificially low). But the market has already priced in a federal funds rate of greater than 2%. On Friday, just as the 10-year yield was falling to 2.81%, the three-month bill was climbing past 2.10%, which is about 20 bps higher than the federal funds rate.

Another 25-basis point hike in the fed funds rate seems like a slam-dunk at the Fed’s September meeting, but another one in mid-December is also warranted. The Fed needs to start getting in front of the curve before it falls further behind.

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George Yacik
INO.com Contributor - Fed & Interest Rates

Disclosure: This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.