Photographer: Andrew Harrer

Yellen Seeks Right Blend of Inflation Data to Raise Rates

Fed Chair Needs Mosaic of Price Data Telling Her It's Liftoff Time

Chair Janet Yellen and her Federal Reserve colleagues are just about finished making promises about short-term interest rates. They want investors to focus instead on indicators related to their mandate to keep inflation stable and employment high. This is how Yellen put it in her written testimony before the House and Senate this week:

Key Yellen

In an exchange with Senator Charles Schumer, the New York Democrat, Yellen said she didn't want to set down "any single criterion" on what it means to be "reasonably confident" that inflation is going to rise back up toward the Fed's 2 percent target. Yellen testified before the Senate Banking Committee Tuesday.

Most economists predict that the broad mosaic of price data will come together sometime this year, so Fed officials can raise the short-term policy rate without the haunting risk of committing an error by raising rates prematurely which forces them to retreat back to zero. The debate is about when. Here are some things to look for:

Labor market slack must continue to diminish

Even though the unemployment rate stood at 5.7 percent in January compared with 6.6 percent a year earlier, Yellen said in her prepared remarks that  "too many Americans remain unemployed or underemployed" and "wage growth is still sluggish." 

There were about 6.8 million Americans working in part-time employment in January who wanted full-time jobs. In 2007, the average was 4.4 million. While these part-time worker numbers are falling closer to pre-recession levels, they have to drop further to help Yellen meet her mandate for full employment and stable prices.

Andrew Levin, an International Monetary Fund economist who served as a policy adviser to former Fed Chair Ben Bernanke and then Yellen from 2010-2012, said inflation will continue to fall short of the Fed’s target as long as so many workers are underemployed and so many others remain too discouraged to search for a job. 

Levin and Dartmouth College professor Danny Blanchflower, a former member of the Bank of England’s Monetary Policy Committee, have found significant correlation between slow wage growth and these measures of employment gaps. They will be presenting that research at a conference in Washington next month, before Levin joins Blanchflower at Dartmouth later this year.  Earlier in February, the two economists said it would be a ''grave mistake'' for Fed officials to raise interest rates around mid-2015. 

Core inflation must stop decelerating, stabilize, eventually rise

low and stable

The consumer price index, minus food and energy (core CPI), rose at a 1.6 percent rate for the 12 months through January, the same as the year through December. 

Michael Gapen, chief U.S. economist at Barclays Capital Inc., said the firm has several models explaining the behavior of core inflation.

"The models that have proven the most reliable over time say core CPI should stabilize at around 1.6 percent year-on-year in May through September," Gapen said. Barclays analysts said today's data on January inflation showed the tug-of-war going on in prices. Goods prices fell partially as a result of the dollar's strength (which makes imports cheaper), while services prices rose. Those forces are going to continue to play out in the benchmark price measure for a few months, keeping it around current levels, they said.

While Gapen predicts the Fed will raise interest rates in June, Barclays ' inflation models suggest September might be better timing, he said. 

Market measures of future inflation need to move higher

Often discredited as a noisy signal, yield differences between U.S. government inflation-linked bonds and Treasury securities are proving useful to the Federal Open Market Committee right now.

This is what policy makers said about this measure of future inflation in the minutes of the January meeting: "Participants generally agreed that the behavior of market-based measures of inflation compensation needed to be monitored closely."  

The Federal Reserve Board also included a separate discussion of long-term inflation expectations derived from market measures in their monetary policy report to Congress this week. The chart below shows why Fed officials are concerned. 

oil and break evens

Average annual inflation starting in 2020 (the blue line) is priced well below the Fed's 2-percent goal and started to sink before oil prices. They are also signaling that longer-run inflation is going to average about 1.6 percent starting five years from now, below the Fed's 2 percent goal, which it has already missed for 32 months. (U.S. government inflation linked bonds are linked to the consumer price index, which trends about three-tenths of a percentage point higher than the Fed's preferred price measure, the personal consumption expenditures price index, or PCE for short.) 

Because investors are making bets on long-run estimates of inflation in these securities, they incorporate a lot of real-time assumptions about how energy prices, the value of the dollar, and the disinflationary trends in Europe might affect the U.S. That may be why Fed officials are now watching this indicator closely.

A rise in inflation expectations would be an important validation that prices have begun to firm for a Fed policy committee that wants to avoid the error of hiking too soon, said Laura Rosner, U.S. economist at BNP Paribas in New York and former New York Fed researcher. She predicts the Fed will wait until September to raise the benchmark lending rate.

"The cost of waiting a little bit so they can be sure inflation expectations are stable and inflation is moving in the right direction is small compared to the cost of raising interest rates too soon and losing credibility," Rosner said.

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