Fed plans more policy tightening but data says no

Federal Reserve plans for gradual interest rate increases hinge on inflation rising to its 2 per cent target, but it is not showing up and the Fed doesn’t know why. This is undermining Fed chair Janet Yellen’s case for further policy tightening.

Over two days of congressional testimony last week, Ms Yellen stuck to the Fed’s outlook for gradually rising inflation that would support additional hikes in policy rate. That was before Friday’s consumer price index report that shows continued weak pricing power in June across a range of goods and services for the fourth consecutive month.

“There is no way of getting around it,” said Laura Rosner, a senior economist and partner at MacroPolicy Perspectives in New York. “The weakness is pretty broad and it is partly happening in cyclical areas of the economy that might be slowing, like motor vehicles.”

At the Fed’s June policy meeting, and in her testimony before US lawmakers, Ms Yellen stuck with the Federal Open Market Committee’s (FOMC) baseline forecast, which predicts increasing resource constraints gradually lifting inflation and supporting another rate increase this year with three more in 2018.

She told the Senate Banking Committee on Thursday that inflation risks were “two-sided”, dismissing some of the weakness in recent reports to “transitory” moves in some categories of the data series.

“It is premature to conclude that the underlying inflation trend is falling well short of 2 per cent,” she said. At her June 14 press conference, Ms Yellen said the committee continues to believe that with a strong labour market, “the conditions are in place for inflation to move up”.

The FOMC’s outlook and Ms Yellen’s comments reflect forecasters’ bedrock understanding of how inflation works. They look at public expectations of prices, near-term inflation performance or “inertia”, and resource-use benchmarks such as estimates on what rate of unemployment begins to trigger higher compensation that fuels demand in the economy.

Expectations have been low but stable, while inflation inertia has shown little upward traction. Right now, central bankers are making a big bet that low rates of unemployment will boost prices eventually. Their estimate for the unemployment rate that keeps supply and demand in balance in the economy is 4.6 per cent. It has been below that rate since March and stood at 4.4 per cent in June.

“They are saying: We don’t see the world as tremendously different and at some point domestic resource scarcity will push inflation up to 2 per cent,” said Michael Gapen, chief US economist at Barclays and a former member of Fed Board staff.

“As long as inertia is due to one-offs, that is, transitory and non-monetary, then they dismiss it,” Mr Gapen added. “But at some point you say maybe that is dumb and shift your tone. They are not there yet.”

US consumer prices slowed to a 1.6 per cent rate for the 12 months ending in June from 1.9 per cent in May.