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By HaleStewart September 20, 2017 3:45 pm
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US Bond Market Week in Review: The Fed is Determined to Get Inflation Wrong

            Today, the Federal Reserve issued their latest monetary policy statement, keeping rates at 1%-1.25%.  They describe the economy as expanding moderately: the labor market continues to grow, households are spending and investment is picking up.  But they once again argued inflation would reach 2% in the medium term.  The evidence doesn’t support this conclusion. If the Fed raise rates later this year, they will be making a policy mistake.

            Here are the three key passage about inflation from the release:

On a 12-month basis, overall inflation and the measure excluding food and energy prices have declined this year and are running below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.

.....

...inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee's 2 percent objective over the medium term

...

The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.

After noting that inflation is below their 2% target, they go on to argue that it will reach 2% in the medium term.  They then argue that current low interest rates will aid in rising prices.

       While the Fed has been making this argument for several years, inflation remains below their 2% target.  Nothing in the current data supports their contention that prices will pick up soon.  Let’s start by looking at the commodity components of CPI:

Energy prices (in red) only recently started to increase on a Y/Y basis.  But these only comprise 7% of CPI.  Food prices (in blue) just turned positive. In the latest CPI release, they only rose 1.1%.  The DBA agricultural ETF is in a 5-year downtrend, indicating food prices are soft.  Other commodities (in green) have been mostly negative for the last five years.  As these represent 19% of the CPI index, their contraction helps to mitigate any increase in food and energy prices.  That leaves the services less energy to get inflation to the Fed’s 2% target:

They were above 3% for most of 2016.  But they have since dropped to 2.5%, where they’ve been for most of the last five years.  This subset of prices would have to maintain a lengthy period above 3% to counter-balance weak commodity prices.  So far, they haven’t done so.

            And nothing in the Fed’s preferred inflation measure supports the Fed’s 2% argument.  I discussed this in a article several weeks ago.  In the interest of time, I’ll simply reference that post:

Durable goods prices (in blue) have been subtracting from price growth for the last 20 years. Non-durable goods prices (in read) have been declining since 2011-2012; they subtracted from PCE price growth for most of 2015 and only recently turned positive. Only service prices (in green) have increased PCE price pressures on a consistent basis.

There are several important lessons to draw from this data. First, the PCE price index looks at prices from a business perspective. According to the Cleveland Fed, “the PCE is based on surveys of what businesses are selling.” The above charts indicate that neither durable goods nor non-durable goods companies have any pricing power. Second, the Y/Y percentage change in service prices has been declining. Third, price growth for 31% of PCEs are either negative or very weak. That means the remaining 70% of prices would have to increase at a faster Y/Y rate to hit the Fed’s 2% PCE Y/Y inflation target. This runs counter to the second conclusion regarding service prices, that the y/y rate of change is narrowing.   

            Two Fed governors recently challenged the Fed’s inflation thinking.  St. Louis President Bullard argued the Phillip’s Curve is at best very flat, taking away a key intellectual underpinning of the Fed’s current inflation thinking.  Lael Brainard recently added further intellectual muscle to this effort.  The rest of the Fed would be wise to listen to these two.    

             

 

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