Inflation expectations are being allowed to wilt, because the hard data is simply not there, creating a negative feedback loop that puts the bank’s credibility at risk.
Washington – A lack of positive price pressures is becoming an increasing threat to the credibility of the Federal Reserve.
Some officials are now even calling for “direct evidence” of inflation moving back to the target 2% before the next rate hike can be administered. Even die-hard hawk James Bullard is now questioning the merits of further increases in interest rates in light of drooping inflation expectations.
Meanwhile, hard data is likely to confirm that rising prices remained confined to the services side of the economy early on this year.
Analysts are projecting the consumer price index to fall 0.1% in January, on top of a similar-sized decline in December.
There is some scope for surprise if the rise in food prices signalled by the data from producers also shows up on the consumer level, although this may not yet be the case in January. What is certain is that further declines in the energy component will drag on the index.
Gasoline prices tanked another 4% last month, according to data from the Energy Information Administration.
The CPI index had been falling this time last year, which is why the annual inflation rate will appear healthier on the surface. Forecasters say the 12-month rate should pick up to 1.3% in January from December’s 0.7%.
Core commodities (other than food and energy) are poised to decline further as a strong dollar keeps the costs of imports grounded. Working against the deflationary impulses will be core services, i.e. shelter, medical care and transportation.
The former component, which accounts for about a third of the total consumer basket, has been largely responsible for pushing the core inflation rate higher over the past year. Even though families certainly feel the pinch when their rents go up, this development offers cold comfort for the Fed.
Shelter costs are rising because of scarce housing inventories, whereas rate setters want to see broad-based strength across a wide array of categories, which would tell them that the economy has exhausted most of the spare resources and is close to reaching its full potential.
Price hikes across the medical care industry have been linked to legislation changes, again offering little consolation to the Fed, and the rising transportation costs can be traced back to higher motor vehicle insurance premiums.
Without the boost from rents, services costs have risen 1.7% over the past year – that is up slightly since last year, but still lackluster in broader terms.
Officially, the Fed targets a different inflation benchmark, one that is tied to consumer outlays, known as the PCE index. Both the headline and the core PCE gauge have been even more timid than their CPI counterpart.
While there are differences how indices are constructed and calculated, they tend to move in lockstep over time, and the CPI offers much more detail than the PCE series, which is why economists like to focus on both sets of data.
All things considered the market expects the core CPI to edge up 0.2% in January. Forecasters assume the core inflation rate should hold at 2.1% over the past year.
“The outlook for inflation remains quite weak, as the disinflationary forces continue to make their way through the price channel,” the economists at TD Securities wrote in their note for Friday. They go as far as predicting the core inflation rate will ease to 1.7% by the end of the year.
This spells trouble for the Fed. Officials have said they are willing to look through the falling energy and import prices as long as they see evidence of inflationary pressures building elsewhere.
Specifically, policymakers expect that as the labour market continues to make strides and that an ever smaller supply of workers will drive up the price of labour. Businesses will then pass on the higher production costs to consumers, thus the economic theory known as the Phillips curve suggests.
However, Bullard believes that inflation expectations heavily determine actual inflation, more than traditional Phillips curve effects.
The Fed generally agrees that expectations play a vital role in realized price increases. Where they differ though are their opinions on what has been driving down market-based measures of inflation expectations, which are now at levels seldom seen outside of a recession.
Simply put, these expectations measure how much extra money investors demand for holding a certain type of government debt as opposed to a different type. That is why they are sometimes referred to as measures of inflation compensation.
The simplest way of calculating these indicators is by subtracting the yield (i.e. interest rate) on treasury securities that are linked to the CPI (inflation-protected treasuries or TIPS) from similar treasuries without such protection.
The difference between the yields of such securities maturing in five years has been only about 120 basis points for the past year compared to over 200 basis points before the recession.
There are several components other than inflation that can impact these figures though, commonly dubbed term premiums. Plus, the measures of inflation compensation have been shown to be sensitive to oil price movements.
Still, their behaviour has been puzzling Fed officials. “I suggested during 2015 that inflation expectations would return to previous levels once oil prices stabilized,” Bullard said. “Since then, inflation expectations have declined too far for comfort, the oil price correlation notwithstanding.”
There are numerous other ways to gauge how inflation will behave in the short- to medium-term. The fact remains that while the Fed has seen the labour side of the economy align with its goals, inflation has consistently failed to do so.
And that would be the glass-half-full-way of putting things, since now it is increasingly looking like price growth is stepping further away from the target.
Article: World Business Press