Prophets

The Fed Needs a New Party Line on Inflation

After a while, continual “special factors” become a deflationary trend in a world where production capacity and labor exceed demand.

The Fed is flying blind.

Photograph: Hulton Archive

Despite the large and growing deflationary pressures, Federal Reserve Chair Janet Yellen stuck to the central bank’s party line in her speech to the National Association for Business Economists in Cleveland on Sept. 26. She argued that the weaker inflation is transitory. Yes, she admitted, the Fed’s 2 percent target for personal consumption expenditures inflation, the central bank’s favorite measure, has been continually undershot, but “the restraint imposed in recent years by a variety of special factors, including movements in the relative prices of food, energy and imports, will wane in coming quarters.”

There are two problems with that statement. First, she’s been saying this for some time, but those “special factors” -- items such as falling mobile-phone service costs, lower airfares, weak oil prices in 2014 through 2016, and declines in education and health care costs -- just keep coming. After a while, continual “special factors” become a deflationary trend, which is fundamentally the result of a world in which supplies of productive capacity and labor exceed demand in most areas.

Second, Yellen, like most forecasters, thinks conditions move to a nice, steady long-run equilibrium. In this case, the Fed sees that nirvana as 2 percent annual inflation, 1.8 percent real gross domestic product growth, a 4.6 percent unemployment rate and a 2.9 percent federal funds rate. But steady states don’t exist for long, and long-run equilibria are simply crossing points through which the economy and financial markets move on their way to high and low extremes. Forecasts of long-run steady states are no more than hyper-quantifications of ignorance.

Real GDP grew at an average annual rate of 3.6 percent from 1949 through 2007, and many look back longingly at those years as ones of consistent stable growth, punctuated by a few brief recessions. In reality, among the 237 four-quarter stretches during those years, only 12 had four consecutive quarters of growth in the 3.4 percent to 3.8 percent range. By that measure, stable growth existed only 5 percent of the time.

Despite all the turmoil of the Great Recession, after the business peak in the fourth quarter of 2007, and erratic economic developments since then, the slow real GDP growth from 2008 to the present has been just as stable. Two of the 38 four-quarter periods during those years had growth in the 1.2 percent to 1.6 percent range, again 0.2 percentage points on either side of the 1.4 percent average. This is also 5 percent of the time.

Yellen did, in her extraordinary speech, go to considerable lengths to admit the Fed’s forecasts have been wide of targets. “My colleagues and I may have misjudged the strength of the labor market, the degree to which longer-run inflation expectations are consistent with our inflation objectives, or even the fundamental forces during inflation.” Wow! She even admitted that “a persistent undershoot of our stated 2 percent goal [for inflation] could undermine [the FOMC's] credibility.”

I’ve said many times that the headline unemployment rate is a poor measure of labor market conditions and Yellen admitted as much when she said it is questionable “whether the unemployment rate alone is an adequate gauge of economic slack for the purpose of explaining inflation,” noting that the employed share of the “prime-age worker” population -- those 25 to 54 -- remains noticeably below the 2007 level.

Yellen also addressed globalization, and how “increased competition from the integration of China and other emerging-market countries into the world economy may have materially restrained price margins and labor compensation in the United States and other advanced countries.” She also gives a nod to the effect on inflation of “the growing importance of online shopping.”

Although she didn’t throw in the towel on the Fed’s chronic forecast that higher wages and faster inflation are just around the corner, Yellen did note that “FOMC participants -- like private forecasters -- have reduced their estimates of the sustainable unemployment rate, especially over the past few years.” She also said the neutral real interest rate -- that is, the inflation-adjusted level of the federal funds rate consistent with keeping the economy on an even keel -- has “declined considerably in recent years, and by some estimates” is “currently close to zero.” She added, “Its value at any point in time cannot be estimated or projected with much certainty.” Translation: The Fed is flying blind.

Yellen may well be paving the way for further delays in Fed tightening, which has been the case for years. So don’t count on another 25 basis-point rate hike in December and three more next year, as the Fed has forecast. And don’t assume big reductions in the central bank’s $4.5 trillion portfolio will occur soon.

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    Gary Shilling at agshilling@bloomberg.net

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    Robert Burgess at bburgess@bloomberg.net

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