Yellen Brushes Aside Inflation ‘Mystery’ While Fed Eyes Rate Hike

  • Dollar, bond yields rise as Fed sticks with gradual tightening
  • Says ‘ongoing strength of the economy’ to warrant more hikes

Yellen Says Inflation Shortfall Is a 'Mystery'

Federal Reserve Chair Janet Yellen acknowledged that the fall in inflation this year was a bit of a “mystery” but suggested that the central bank was on course to raise interest rates again in 2017 nonetheless.

She told reporters on Wednesday that the economy was robust enough to withstand further rate increases and an imminent reduction in the Fed’s $4.5 trillion balance sheet, as it exits from a crisis-era policy a decade after the onset of the Great Recession.

“We continue to expect that the ongoing strength of the economy will warrant gradual increases” in rates, she told a press conference after the Federal Open Market Committee announced that it will slowly begin to pare its bond holdings next month. As expected, the target range for the federal funds rate was held at 1 percent to 1.25 percent.

The central bank’s intention to press ahead with another rate hike this year and three more in 2018 caught investors by surprise, sending bond yields and the dollar higher. The strategy represents a bit of a gamble because it risks cementing inflation permanently below the Fed’s 2 percent target.

As measured by the personal consumption expenditures price index, inflation has ebbed this year even as the economy and the labor market have continued to improve. After briefly poking above 2 percent earlier this year, it fell to 1.4 percent in June and July.

“I will not say that the committee clearly understands what the causes are of that,” Yellen, 71, said.

While transitory forces such as a one-time cut in mobile-phone service charges were part of the story, they did not fully explain the shortfall, she said.

The Fed chief though argued that the ongoing strength of the economy and the labor market would ultimately help lift inflation, while she kept open the possibility the central bank would alter course if that proved not to be the case.

“Yellen is banking on the theory that an economy at full employment eventually leads to greater inflation,” said Chris Rupkey, chief financial economist with Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. “Too-low inflation is probably not the thing that concerns an old hand like Yellen with decades of experience” watching inflation rise and fall.

The Fed’s efforts to gauge where the economy and inflation are headed will be complicated in coming months by a recent spate of hurricanes that struck the U.S.

Yellen said inflation may be lifted by higher prices for gasoline and other items while growth will be depressed by the devastation caused by the storms. But history suggests those effects will prove to be temporary, she said.

The centerpiece of this week’s Fed meeting was its announcement that it will begin to reduce its balance sheet next month. It was the culmination of months of careful preparation and marked a milestone in the central bank’s efforts to normalize monetary policy.

It comes a decade after the global financial crisis began to tip the economy into a recession at the end of 2007. The reduction in assets will be slow -- just $10 billion a month to start -- and will come even as the European Central Bank and the Bank of Japan continue to add to their holdings.

“The reason for our actions today in beginning to run down the balance sheet is, we think the economy is performing well, and we have confidence in the outlook for the real economy,” Yellen said.

It was a testimony to the central bank’s painstaking efforts to prepare the financial markets for the draw-down that most of the post-meeting commentary focused on the Fed’s plans for interest rates, rather than the balance sheet.

“The center of the committee appears to plan for another rate hike in December, notwithstanding low inflation, although it could still go either way,” said Jonathan Wright, an economics professor at Johns Hopkins University in Baltimore and a former Fed economist.

While sticking to their forecasts of another rate increase this year and three more in 2018, policy makers did trim their long-term estimate of the rate that keeps the economy in balance to a median of 2.75 percent, from 3 percent in the June projection.

“We are moving slowly away from this grand experiment” of very low interest rates, said Eric Stein, co-director of global income at Eaton Vance Management in Boston. “We are in a strange time. Inflation is lower. I don’t think that is something the Fed should ignore, and it gives them more time and more latitude to move more slowly.”

— With assistance by Steve Matthews, Craig Torres, and Christopher Condon

    Before it's here, it's on the Bloomberg Terminal.