Fed Aim Off Target as Inflation Descends Near Danger Zone

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Former Fed Governor Laurence Meyer
Former Federal Reserve Governor Laurence Meyer said too-low inflation is getting to be a real issue again.

Federal Reserve officials are hunting for new tactics to raise price increases to their target as slowing global growth, cheaper commodities and flat wages sound warnings that inflation is descending toward the danger zone.

The Fed needs a clear strategy for getting the inflation rate higher after falling short of its 2 percent target for 28 consecutive months.

Now, as longer-run inflation expectations erode in financial markets, the Federal Open Market Committee is shifting its focus toward prices after putting its main emphasis on jobs for months. Several officials worried that “inflation might persist below” the committee’s target for “quite some time,” minutes from the Sept. 16-17 meeting said.

Too-low inflation “is getting to be a real issue again,” said former Fed Governor Laurence Meyer. With inflation at 1.5 percent according to the Fed’s preferred index, Meyer said FOMC policy makers aren’t likely to raise interest rates, even if the economy approaches full employment, defined as a jobless rate of 5.2 percent to 5.5 percent. Unemployment was 5.9 percent last month.

“The timing of the first rate hike is all about inflation,” said Meyer, now a senior managing director at Macroeconomic Advisers LLC in Washington.

Policy makers including regional Fed Presidents William Dudley of New York, Charles Evans of Chicago and Narayana Kocherlakota of Minneapolis have in recent days all mentioned below-target inflation as a risk that weighs against raising interest rates too soon.

Vicious Circle

An inflation rate approaching zero is bad for the economy because of its impact on behavior by businesses and consumers. Companies’ inability to raise prices hurts profits, and they rarely compensate by cutting wages, so they fire workers instead. Consumers anticipating falling prices may postpone discretionary purchases. This can combine to create a vicious circle of less spending and further downward pressure on prices.

Prices fell 1.2 percent for the 12 months ending in July 2009, when the economy had just exited the recession, according to the inflation measure the Fed uses, the personal consumption expenditures price index. Unemployment that month was 9.5 percent. Since Fed officials first published their inflation target in January 2012, the index has averaged 1.5 percent.

“It is a reflection of a lousy recovery,” said Adam Posen, a former member of the Bank of England’s Monetary Policy Committee who now leads the Peterson Institute for International Economics in Washington.

“As we are seeing in the euro area, and as we saw in Japan, if you let it go on for too long it becomes a lock-in, it reinforces a bad outcome,” he said.

Lost Decade

Japan’s lost decade of the 1990s came after the Bank of Japan raised interest rates in 1989. That was followed by the collapse of a real-estate bubble and falling consumer prices.

Fed officials now have two problems, and both are growing in urgency.

First, events in global markets and economies exert further downward pressure on U.S. prices. West Texas Intermediate oil is down more than 20 percent from this year’s June peak; wages were flat in September, according to Labor Department figures, and the Fed’s trade-weighted dollar index is up 4.5 percent year-to-date.

A stronger dollar makes it cheaper for Americans to pay for imported goods. A 10 percent increase in the dollar versus currencies of major trading partners could trim inflation by a quarter percentage point, said Michael Hanson, U.S. senior economist at Bank of America Merrill Lynch in New York.

A second problem is that Fed policy makers have failed to communicate a plan to hit their inflation target, said Diane Swonk, chief economist at Mesirow Financial Holdings Inc. in Chicago.

Policy Goals

The 2 percent inflation objective first appeared in a January 2012 statement on longer-run policy goals, and has been restated each January since. The statements say nothing about tactics for returning inflation to 2 percent over the medium term.

What’s more, since January 2012, every one of Fed officials’ central tendency forecasts, which toss out the three highest and three lowest estimates, has projected the top end of the range for inflation for the two years ahead at 2 percent or less.

Swonk said the forecasts are suggesting to market participants that 2 percent is an inflation ceiling, even though Janet Yellen, as vice chair in 2012, said the target “must be treated as a central tendency around which inflation fluctuates.”

Yellen’s “message isn’t getting through,” Swonk said. “They have stated it frequently, but it is not in their forecasts.”

Market Expectations

Market measures of inflation expectations have deteriorated since the Fed’s Sept. 16-17 meeting, when policy makers signaled their intent to raise rates at a slightly faster pace in 2015.

Inflation starting five years from now is expected to average 2.14 percent a year on the consumer price index, down from the 2.38 percent projected just before the September meeting, according to yield differences on Treasury Inflation Protected Securities and nominal Treasuries.

“If the evidence continues to look the way it looks now, you will see stronger language and stronger steps” from the FOMC, said Jon Faust, director of the Center for Financial Economics at Johns Hopkins University in Baltimore, who served as a special adviser to the Fed board earlier this year.

More Commentary

“I don’t think the committee to a person is happy with inflation of 1.5 percent,” Hanson said. “We will get a little more commentary from Fed officials that says, ‘We need to see more signs of inflation going back up’” before raising interest rates.

As Fed officials prepared their policy goals statement in January, some wanted an explicit signal that inflation remaining “persistently below” the target was as undesirable as remaining above it, according to meeting minutes. After becoming Fed chair this year, Yellen appointed a subcommittee to study Fed communications. Fed spokesman Doug Tillett said he was “not in a position to confirm what the subcommittee is or is not working on.”

Symmetric Goal

Both Evans and Kocherlakota said the Fed needs to reaffirm that the 2 percent goal is symmetric, that is, the Fed will take action to keep inflation from going too far below the target as well as too far above it.

“Although the FOMC has a 2 percent inflation objective over the long run, it has not specified any time frame for achieving that objective,” Kocherlakota said in an Oct. 7 speech in Rapid City, South Dakota.

One concrete step the FOMC could take would be to announce a two-year deadline for returning inflation to the goal, he said.

Evans told reporters Oct. 8 that the committee needs to constantly assert that the target is symmetric, and policy makers shouldn’t worry about overshooting 2 percent slightly.

“When we try to thread the needle and try to bring it in just at 2 percent, and not overshoot, that means that there’s some risk that we’re not actually going to get there,” Evans told reporters in Plymouth, Wisconsin. “If we were to allow inflation to stay at 1.5 percent for an extended period of time when our target is 2 percent -- that would be a remarkably negative hit to our credibility.”

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