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By HaleStewart June 14, 2017 4:19 pm
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US Bond Market Week in Review: The Fed is Missing the Inflation Picture

          On Wednesday, the Fed voted to raise interest rates 25 basis points.  To support their argument, they observed that “the labor market has continued to strengthen and that economic activity has been rising moderately so far this year. Job gains have moderated but have been solid, on average, since the beginning of the year, and the unemployment rate has declined.”  The following charts use data from the latest BLS employment report:

The 3 and 6 month moving averages of establishment job growth (top and bottom chart, respectively) are moving lower – the 3 month, more so.  Several Fed governors have argued diminishing establishment growth is sign of a maturing jobs market.  While the latest employment report was somewhat concerning, the low level of the 4-week moving average of initial jobless and labor utilization (which implies that workers could re-enter the job market) indicate the current labor market is taut and that additional employees could re-enter the job market.

     Prices are a different story.  In the FOMC release, the Fed first observes, “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.”  Yet the Fed hedge's their bets in several other places.  They first note inflation has been weak: “On a 12-month basis, inflation has declined recently and, like the measure excluding food and energy prices, is running somewhat below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.” And as for future inflation developments, the Fed stated,” The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal.”  They made no such statement about the labor market.  The absence of concern about the jobs market indicates the Fed may be more worried about inflation than they want to let on. 

            And they have reason to be concerned.  Consider the following 2 charts from the latest inflation report:

Overall and core inflation (top chart) are now below the Fed's 2% target.  The bottom chart shows energy and food prices.  Food prices currently have no impact on overall CPI.  Energy costs drove the recent CPI increase.  But now energy prices are declining.  And according to recent IEA analysis, this trend should continue:

A resurgent US shale oil industry will see global supplies grow faster than demand in 2018, the International Energy Agency forecast on Wednesday, dealing a blow to Opec and other rival producers that have cut output hoping to boost prices.

The IEA expects global demand will increase by 1.4m barrels a day next year — up from 1.3m b/d in 2017 — as China and India take total consumption above 100m b/d for the first time in the second half of the year.

But this increase in demand is set to be outpaced by growth in supply. Total non-Opec production in 2018, led by the US, is set to rise by 1.5m b/d — or more than double the rate of growth this year.

     This might be why a group of prominent economists recently penned an open letter to the Fed asking them to rethink their 2% inflation target:

One of these key parameters is the rate of inflation targeted by the Federal Reserve. In years past, a 2 percent inflation target seemed to give ample leverage with which the Fed could lower real interest rates. But given the evidence that the equilibrium interest rate had fallen substantially even prior to the financial crisis, and that the Fed’s short-term policy rate remained at zero for seven years without sparking any large acceleration of aggregate demand growth, a reassessment of this target seems warranted. Such a reassessment is particularly appropriate when the lack of evidence that moderately higher inflation would harm Americans’ standard of living is juxtaposed with the tremendous evidence that a tighter labor market would improve Americans’ standards of living.

Some Federal Reserve policymakers have acknowledged these shifting realities and indicated their willingness to reconsider the appropriate target level. For example, San Francisco Federal Reserve President John Williams noted the need for central banks to “adapt policy to changing economic circumstances,” in suggesting a higher inflation target, and Boston Federal Reserve President Eric Rosengren cited the different context in which the inflation target was set in emphasizing the need for debate about the right target.[1] [2]

In May, Vice Chair Stanley Fischer highlighted the Canadian system of reconsidering the inflation target every five years, saying, “I can envisage–say, in the case of inflation targeting–a procedure in which you change the target or you change the other variables that are involved on some regular basis and through some regular participation.”[3]

The comments made by Fischer, Rosengren, and Williams all underscore the ample evidence that the long-term neutral rate of interest may have fallen. Even if a 2 percent inflation target set an appropriate balance a decade ago, it is increasingly clear that the underlying changes in the economy would mean that, whatever the correct rate was then, it would be higher today. To ensure the future effectiveness of monetary policy in stabilizing the economy after negative shocks–specifically, to avoid the zero lower bound on the funds rate–this fall in the neutral rate may well need to be met with an increase in the long-run inflation target set by the Fed.

More immediately, new, post-crisis economic conditions suggest that a reiteration of the meaning of the Fed’s current target is in order. In its 2016 statement of long-run goals and strategy, the Federal Open Market Committee wrote: “The Committee would be concerned if inflation were running persistently above or below this objective.” Some FOMC participants, however, appear to instead consider 2 percent a hard ceiling that should never be breached, and justify their decision-making on that basis. It is important that the Federal Reserve makes clear–and operates policy based on–its stated goal that it aims to avoid inflation being either below or above its target.

Economies change over time. Recent decades have seen growing evidence that developed economies have harder times generating faster growth in aggregate demand than in decades past. Policymakers must be willing to rigorously assess the costs and benefits of previously-accepted policy parameters in response to economic changes.

This argument makes a great deal of sense.

 

Hale Stewart is a tax lawyer in Houston, Texas with the Law Office of Hale Stewart, where he specializes in domestic and international tax structures and asset protection.  He is also a financial adviser with Thompson Creek Wealth Advisers.  You can follow me on Twitter at @originalbonddad

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