Fed Still Concerned by Low Inflation as Rate Liftoff Nears

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Yellen's Fed Dilemma: Global Issues Weigh on a Rate Hike

Federal Reserve officials signaled concern about stubbornly low inflation even as they indicated that an improving job market is bringing them closer to the first interest-rate increase in almost a decade.

Participants in the July 28-29 Federal Open Market Committee meeting said economic conditions “were approaching that point” where the economy could sustain a slight increase in borrowing costs, according to minutes of the meeting released in Washington on Wednesday.

Preserving their flexibility on the timing of rate liftoff, they also showed more concern about how soon they would hit their 2 percent inflation target, a goal they have missed for more than three years.

Their debate was silent on whether they should act in September or delay to await more evidence that inflation is heading higher. That discussion highlights a dilemma for the data-dependent FOMC: As the job market continues to deliver robust gains, with unemployment at 5.3 percent, holding interest rates near zero is harder to justify as the expansion enters its seventh year.

At the same time, officials want to avoid the error of tightening policy too soon, especially when inflation gauges remain persistently weak.

“I did sense more caution about whether inflation is on course to move back up to target,” said Jonathan Wright, a professor at Johns Hopkins University in Baltimore and a former economist at the Fed’s Division of Monetary Affairs. “The minutes expressed doubts that diminishing resource slack was going to move inflation back up much.”

Inflation Concern

The committee’s hand-wringing over its inflation goal was interpreted by investors as a lack of conviction they would be ready to raise rates at the Sept. 16-17 FOMC meeting. The probability of a September rate increase fell to 36 percent, according to prices in the federal funds futures markets, from 50 percent earlier on Wednesday.

Wright said the committee gave “no strong signal” on September and in his view it was “a coin-toss between September or December.” The FOMC’s October meeting will not be followed by a press conference. Fed Chair Janet Yellen says every meeting is “live” for a rate decision, though most economists say she would rather act at a meeting after which she could immediately speak with reporters.

During their discussion, officials last month “noted that considerable uncertainty remained” about when wages would rise and “whether that development might translate into increased price inflation.”

Chinese Risks

Global commodity prices have slumped, due in part to a Chinese slowdown, and this could maintain downward pressure on inflation, while U.S. wage increases have been stuck in a narrow range of about 2 percent annually since the recovery began in June 2009.

Several officials warned at last month’s meeting that slower Chinese growth may pose risks to the U.S. economic outlook.

The International Monetary Fund in July notched down its forecast for global growth this year to 3.3 percent, after saying in June that the Fed should delay liftoff until the first half of 2016.

“For every argument you can make that the economy is strengthening, there are compelling arguments to be made that conditions are extremely fragile,” said Mark Vitner, senior economist at Wells Fargo Securities in Charlotte, North Carolina.

The minutes said “many” officials “continued to see some downside risks arising from economic and financial developments abroad” though the risks to the domestic outlook were “nearly balanced.”

The labor market has shown continued progress since the FOMC meeting, with U.S. employers adding 215,000 jobs in July compared with the year-to-date monthly average of 211,000.

While “most members” of the FOMC saw room to let labor market slack diminish further, “several” viewed current conditions “as at or very close to those consistent with maximum employment.”

Data-dependence under Chair Yellen means that committee can shift its emphasis from labor markets, to inflation, to global economic stability as it seeks the right conditions to raise rates, said Matthew Whitbread, an investment manager at Baring Asset Management in Boston.

While the committee raised more concerns about inflation, the minutes also reflected the intent to raise rates as soon as possible, he said.

“The discussion revolves around policy normalization,” he said, and in his view that begins in September with a quarter-point rate hike. “Nothing in these minutes would lead me to believe that this would not be the case.”

For more, read this QuickTake: The Fed’s Countdown