Yellen’s First Challenge: Coping With Too-Low InflationCaroline Salas Gage
One of Janet Yellen’s first challenges as Federal Reserve chairman is generating enough inflation to meet the central bank’s target of 2 percent.
Policy makers have failed to attain their goal for almost two years and now are paring the pace of their bond buying. Inflation rose at a 0.9 percent rate for the 12 months ending in November, according to the central bank’s preferred measure. The last time prices were climbing at or above 2 percent was in April 2012.
“Every month that passes with inflation stuck below the target, the pressure to come up with a plan to deal with it grows,” said Ethan Harris, co-head of global economics research at Bank of America Corp. in New York. “They are slowly acknowledging that this is a serious risk.”
Eric Rosengren, president of the Federal Reserve Bank of Boston, said in a Jan. 7 speech that too-low inflation can be “a cause for real concern” because it increases the possibility a “negative shock” to the economy may lead to deflation. That could cause households to delay purchases in anticipation of even lower prices and companies to postpone investment and hiring as demand for their products dries up. Too-low inflation also means higher inflation-adjusted interest rates, making it harder to achieve a sufficient pace of growth.
“Furthermore, persistently low inflation can theoretically undermine the credibility of the central bank,” said Rosengren, who dissented against the December decision to cut monthly bond buying by $10 billion. If the Fed announces a goal “but is unable to achieve that target in a reasonable time frame, some may call into question its ability to do so in the medium- or long-term as well.”
Officials justified their Dec. 18 decision to cut monthly asset purchases to $75 billion by citing improvement in the job market, convincing investors the taper didn’t constitute a tightening of policy by also extending the timeline for zero interest rates.
Yellen, who won Senate approval this month to succeed Ben S. Bernanke as chairman on Feb. 1, will need to reinforce that rate commitment to ward off the threat of disinflation, according to Harris, a former New York Fed researcher.
“She’s going to have to step up and pretty clearly clarify to the markets” how she’s “going to deal with low inflation,” he said. “It slows down the whole exit, both in terms of the speed of tapering and timing of the first rate hike.”
The policy-setting Federal Open Market Committee, which starts a two-day meeting tomorrow, said last month it “recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully.”
The FOMC decided to cut the pace of bond purchases “in light of the cumulative progress toward maximum employment and the improvement in the outlook for labor-market conditions,” according to the committee’s Dec. 18 statement. Unemployment dropped to 6.7 percent in December, the lowest since October 2008. The decline has come partly because of discouraged workers leaving the labor force.
While the Fed has made “significant progress,” there is still “this question about inflation,” Bernanke said at a Dec. 18 press conference in Washington. “We take that very seriously.”
Inflation may accelerate because some “special factors, such as health-care costs” that have been “unusually low,” could reverse, Bernanke said. Inflation expectations also indicate a pickup, he added.
Prices will rise at a 1.87 percent pace during the next five years, as measured by the break-even rate for five-year Treasury Inflation Protected Securities, a yield differential between the inflation-linked debt and Treasuries. The rate measures projections for consumer prices over the life of the securities and is down from 1.94 percent on Jan. 9.
Inflation has been slower than expected also because education costs may not be rising as quickly as in the past, and prices of goods such as new cars and apparel “are quite benign because, frankly, the economy hasn’t been that strong,” said Stephen Stanley, chief economist at Pierpont Securities LLC in Stamford, Connecticut.
While gross domestic product rose at a 4.1 percent annual pace in the third quarter of 2013, growth was 1.1 percent and 2.5 percent in the first and second quarters.
Yellen, 67, may get “a pass for a while” on criticism of too-low inflation because she inherited it; still, “missing by 1 percent year after year is a problem,” said Stanley, a former Richmond Fed researcher. “They’re probably going to be patient at 1 percent, but if it were to start moving down further, that would be the point at which they’d start to worry.”
Fed officials cut their forecast for inflation in December as they raised their assessment of the labor market. They said that prices, measured by the personal-consumption-expenditures price index, would rise 1.4 percent to 1.6 percent this year, compared with September’s 1.3 percent to 1.8 percent, according to their central-tendency estimates, which eliminate the three highest and three lowest projections.
None of the policy makers predicted the Fed would achieve its 2 percent goal this year.
“We’re calling inflation ‘the new unemployment rate’ as far as policy is concerned,” because “the Fed is shifting its attention,” said Dana Saporta, an economist at Credit Suisse Group AG in New York. “Why inflation is running so far below the Fed’s target is not easy to answer, especially with all of the stimulus that’s been thrown at the problem.”
The Fed has kept its benchmark interest rate near zero since December 2008 and expanded its balance sheet to a record of more than $4 trillion through three rounds of asset purchases or so-called quantitative easing. The second round, known as QE2, was announced in 2010 and sparked the harshest backlash against the Fed in three decades, with Republicans including House Speaker John Boehner of Ohio criticizing the stimulus for risking a rapid acceleration in prices.
“To some degree, QE was less effective than anticipated,” said Stanley, who thought inflation would rise faster than it has. Given the Fed now is tapering its bond purchases, its main remaining stimulus option is communication about the future path of policy, he said.
That communication may be made more difficult if prices accelerate. Policy makers were able to engineer the pullback of their bond-buying program in December without unhinging financial markets by convincing investors the timeline for zero interest rates had been extended. With higher inflation, that message may not be as credible, Saporta said.
“If inflation does start picking up, then the Fed is really going to have a challenge in explaining to the market why it’s keeping its rate target near zero when unemployment is falling much faster than the Fed expected and disinflation is less of a problem,” Saporta said. “You have to be careful what you wish for.”
Policy makers reinforced their assurances that interest-rate increases are far off by saying last month their benchmark rate probably will stay low “well past the time that the unemployment rate declines below 6.5 percent, especially if projected inflation continues to run below” their 2 percent target.
While central bankers may be running out of new ways to try to boost growth, their unprecedented accommodation so far has kept inflation expectations from falling because investors have confidence the Fed will do whatever it can to prevent deflation, Saporta said.
Yellen will to have to lean harder on the message of a slow exit to keep those expectations up, Bank of America’s Harris said. Once they “start to drop, you’ve already lost the war.”
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