Inflation Isn't Cooperating With the Fed
The Federal Reserve can’t catch a break on the inflation numbers, which are simply not helping in its drive to normalize monetary policy.
Monetary policy makers have three possible responses to the weak inflation data. First, they can define down the extent of an acceptable miss on their target. Second, they can dismiss the numbers as transitory and focus instead on full employment. Third, they can rethink their estimates of full employment and the subsequent implications for the path of interest rates.
Early indications are that the Fed will pursue some combination of the first two options. That means a June rate hike remains the best bet. But if inflation stays low into the latter half of this year, the Fed will eventually turn to the third option and adjust down the expected path of tightening. For the moment though, expect Fedspeak to dismiss this option.
Consumer price inflation was soft in April, after a surprise drop in March:
So, is this a head fake? The Fed will want to see it that way. Like the first quarter gross domestic product numbers, it will look at the low unemployment rate and attempt to conclude that the recent inflation numbers are transitory and thus that the basic forecasts can remain in place. Hence policy makers will keep a laser focus on June as the next opportunity to tighten up policy a notch.
Still, the central bank is taking a bit of a risk with this approach. It was little noticed that the economy may have drifted away from the Fed’s mandate in March (we don’t have April personal consumption expenditures price data yet). This can be illustrated with the Fed objective function utilized by St. Louis Federal Reserve President James Bullard:
Deviations from zero increase the further the Fed is from meeting its inflation or employment mandates. In this framework, the errors have a symmetric impact; an inflation outcome above target has the same cost as one below target. The same is true for unemployment. The Fed is currently missing its mandate because both inflation and unemployment are too low:
Low unemployment argues for tighter policy; low inflation argues for easier policy. The Fed has prioritized the former over the latter on the theory that an economy operating beyond full employment will place upward pressure on inflation. And recent indications of a bounce in growth in the second quarter will only strengthen policy makers' resolve.
That theory, however, is being put to a test. Or at least the Fed’s estimate of full employment is. The current median estimate of 4.7 percent is starting to feel a bit high. And it will definitely feel too high if current trends -- falling unemployment and low inflation -- continue to hold into the back half of 2017. One has to imagine that the Fed would have to yield and once again conclude that its estimate of full employment remains too pessimistic.
Then again, maybe Fed officials would fight this interpretation. After all, at the moment, they are not yielding in their drive for tighter policy. “We are pretty close to full employment,” New York Federal Reserve President William Dudley said after a speech in Mumbai on May 11:
Inflation is just a little bit below our target of 2 percent if you look at the underlying inflation trend, so clearly if the economy continues to grow above trend we are going to want to gradually remove monetary policy accommodation.
There is something very revealing in this quote. Looking at the underlying inflation trend, core PCE inflation was 1.6 percent in March. Dudley describes this as “just a little bit” below the Fed's 2 percent target. So rather than consider that the bank's estimate of full employment is too high, Dudley is effectively declaring “mission accomplished” on both mandates.
Moreover, as long as the Fed maintains a “mission accomplished” view, it will remain attached to current policy projections of two more rate hikes this year plus likely balance sheet action. The Fed seems committed to this course of action as long as broader economic and, in related fashion, job growth, remains on track. Inflation, it seems, is something of a second order concern as long as the bank can credibly claim the forecast shows a return to the 2 percent target over the medium term.
Eventually, the Fed will return to worries that its repeated failure on the inflation target will entrench expectations on the wrong side of the 2 percent target. But that day is not yet at hand. Be wary that the Fed has a change of heart in the second half of this year. And if it doesn't while inflation remains low, be wary that policy makers get too far ahead of the curve in short order.
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