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By HaleStewart November 26, 2017 7:08 am
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US Bond Market Week in Review: Is the Fed's Inflation Thinking Finally Changing?

            This expansion has been difficult for the Fed due to its dual mandate.  The jobs market is near full employment, save for the weaker utilization numbers, which fulfills half of the Fed's dual mandate  Prices are a different story.  For the last few years, economic commentators have noted the dichotomy between the Fed’s rosy inflation predictions – which continually project PCE inflation at 2% in the intermediate term – and the underlying trend, which has been weaker than the central bank’s projections.  Slowly Fed governors noted the weakness.  In this month’s meetings, it appears a majority of Fed governors have become aware of this expansion’s weaker price pressures. 

            There is near universal consensus among the policymaking committee members that the economy is near full employment.  There is a great deal of statistical support for this conclusion.  The unemployment rate is 4.1% and the U-6 rate is 7.9% -which is lower than the best level achieved during the previous expansion.  Another positive is the employment/population ratio, which continues to increase.  The labor force participation rate has stabilized between 62.8% and 63%.  As the baby boomers are now retiring in mass, this is probably the best rate will see for the LFPR.

            It appears the Fed’s thinking on inflation is changing.

With core inflation readings continuing to surprise on the downside, however, many participants observed that there was some likelihood that inflation might remain below 2 percent for longer than they currently expected.

For some time, Neil Kashkari and Lael Brainard were the only Fed governors acknowledging weak price pressures.  Now the minutes state that “many” participants believe inflation could run cooler than projected over the intermediate term.  This is a very important development.

The Committee next discussed possible reasons for weak price pressures:

Several participants pointed to a diminished responsiveness of inflation to resource utilization, to the possibility that the degree of labor market tightness was less than currently estimated, or to lags in the response of inflation to greater resource utilization as plausible explanations for the continued soft readings on inflation. A few noted that secular influences, such as the effect of technological innovation in disrupting existing business models, were likely offsetting cyclical upward pressure on inflation and contributing to below-target inflation.

The phrase “resource utilization” refers to the labor market.  Despite low unemployment, wage growth has been weak – a development that has confounded economists and some Fed governors.  “Labor market tightness” is a euphemism for the lower labor force participation rate.  Some have theorized that the declining LFPR is at least partially responsible for weaker wage growth.  Other theories that have been advanced to explain weaker price pressures include the increased impact of international trade, the globalization of supply chains, and the “Amazon effect,” where consumers have real-time access to price information, enabling them to always obtain the lowest market price.  In Fed speak, this is referred to as “the effect of technological innovation.”  The inclusion of this term on in the Minutes likely indicates this is argument is gaining the most credence among policymakers.      

            The committee also discussed if lower inflation was beginning to lower inflation expectations:

In discussing the implications of these developments, several participants expressed concern that the persistently weak inflation data could lead to a decline in longer-term inflation expectations or may have done so already; they pointed to low market-based measures of inflation compensation, declines in some survey measures of inflation expectations, or evidence from statistical models suggesting that the underlying trend in inflation had fallen in recent years.

This is, in fact, happening:


The 5-year rate (top chart) clustered around 2% during the early part of this expansion but has been below that level since the beginning of 2014.  There’s been a marked deterioration in the 10-year rate (bottom chart), which has fallen about 60 BPs 2013.

            However, the Fed is still waiting for the inflation Godot: “Inflation on a 12-month basis was 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.”  But they did add a very important caveat:

Members reaffirmed their expectation that economic conditions would evolve in a manner that would warrant gradual increases in the federal funds rate, and that the federal funds rate was likely to remain, for some time, below levels that are expected to prevail in the longer run. Nonetheless, they reiterated that the actual path of the federal funds rate would depend on the economic outlook as informed by incoming data. In particular, members noted that they would carefully monitor actual and expected inflation developments relative to the Committee's symmetric inflation goal. Some members expressed concerns about the outlook for inflation expectations and inflation; they emphasized that, in considering the timing of further adjustments in the federal funds rate, they would be evaluating incoming information to assess the likelihood that recent low readings on inflation were transitory and that inflation was on a trajectory consistent with achieving the Committee's 2 percent objective over the medium term.

This is very good news.  It indicates that more Fed governors are noticing low inflation are more than willing to act on it should it persist.

In 2009, F. Hale Stewart, JD. LL.M. graduated magna cum laude from Thomas Jefferson School of Law’s LLM Program.  He is the author of three books: U.S. Captive Insurance LawCaptive Insurance in Plain English and The Lifetime Income Security Solution.  He also provides commentary to the Tax Analysts News Service, as well as economic analysis  to TLRAnalytics and the Bonddad Blog.  He is also an investment adviser with Thompson Creek Wealth Advisors. 


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