Yellen Wonders If Fed Inflation Credibility Dented on Her Watch

  • Fed chief sees some evidence inflation expectations slipped
  • Yellen though still thinks they’re anchored at 2 percent

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Federal Reserve Chair Janet Yellen has begun to openly acknowledge the possibility that the credibility of the central bank’s 2 percent inflation goal may have weakened somewhat -- a surprising admission in what could be the final months of her tenure.

“I must admit that there is some evidence that inflation expectations could have slipped,” she told the National Economists Club in Washington on Oct 20. While she believes they are still well anchored and consistent with the Fed’s target, “that’s something that cannot and should not be taken for granted.”

That was no off-hand observation, even though it came in response to a question. Just five days earlier, in a speech to a banking conference in Washington, Yellen said it was an “open question” whether inflation expectations in major economies had edged lower.

If they have, that could pose difficulties for whoever heads the Fed next year. Expectations shape how households and companies act and thus help determine where inflation actually ends up. If consumers lose faith in the credibility of the Fed’s inflation objective, they will resist paying up for goods and services. Companies, in turn, will avoid handing out wage increases. It’s a vicious circle that can constrain the Fed from lifting inflation, which has been under 2 percent for most of the past five years.

“They’ve got a problem,” said Vincent Reinhart, a former Fed official who is now chief economist at Standish Mellon Asset Management Co.

Yellen’s questioning is not expected to blow the Fed off course from raising interest rates for a third time this year. While officials are seen holding policy steady at their meeting next week, investors have priced in an almost 85 percent probability they’ll increase rates in December, according to trading in the federal funds futures market. The Fed’s current target range is 1 percent to 1.25 percent.

Such misgivings though could shape the Fed’s strategy for next year and beyond, especially if inflation fails to pick up as central bankers predict. Policy makers, who penciled in three rate increases for 2018 when they met in September, will provide updated forecasts at their December gathering.

Gradual Path

“You could see them tighten in December and maybe then look to do two extra hikes by the end of 2018” instead of three, said Jonathan Wright, an economics professor at Johns Hopkins University in Baltimore and a former Fed economist.

Reinhart said policy makers also might lower their estimate of the long-run neutral rate of interest in the belief that would help prop up price expectations. In September, they put that rate -- which aims to neither restrict nor spur economic growth -- at 2.8 percent.

The future path of rates will also be determined by who’s in charge of the Fed. Yellen, whose four-year term expires on Feb. 3, is among a handful of candidates that President Donald Trump is considering nominating for the post.

During her tenure, Yellen has succeeded in driving down joblessness, from 6.6 percent when she took over in February 2014 to 4.2 percent in September, a level many economists consider equivalent to full employment.

But she’s failed to lift inflation to the Fed’s goal. The annual increase in the personal consumption expenditures price index has averaged just 1.1 percent during her time atop the Fed. That’s even below the 1.3 percent average that’s prevailed since the target was adopted in January 2012.

Grave Concern

“It is a grave concern we’ve had five to six years in which inflation has persistently undershot our objective,” Yellen said on Oct. 20.

She pointed to household surveys and trading in the Treasury bond market in discussing the possibility that price outlooks may have slipped.

Consumers anticipate that annual price rises will average 2.4 percent in future years, according to a University of Michigan poll this month. That’s down from 2.9 percent in February 2014.

While the October reading is above the central bank’s target, Fed researchers argue that it should be adjusted downwards by one percentage point to make it consistent with government data.

That “suggests that consumers’ expectations are roughly consistent with officially measured inflation over the next five to 10 years that is below the Federal Reserve’s objective of 2 percent,” Alan Detmeister, David Lebow, and Ekaterina Peneva wrote in December 2016 note.

Falling Short

Investors also see the Fed falling short, according to trading in the market for Treasury Inflation-Protected Securities, though central bankers have cautioned that those readings can be muddied by hedging and other factors.

Traders currently project average annual increases in the consumer price index of 1.9 percent over the next 10 years. That’s more of a shortfall than seems at first glance because the CPI has historically run about a quarter percentage point above the PCE index targeted by the Fed.

In her Oct. 15 speech, Yellen laid out other potential reasons to explain why inflation has been surprisingly soft this year.

They included the possibility that there’s more slack in the labor market than is commonly believed and technological developments such as “the tremendous growth of online shopping,” though she repeated her belief that price pressures will build in 2018.

“My best guess is that these soft readings will not persist, and with the ongoing strengthening of labor markets, I expect inflation to move higher next year,” she said.

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