The Fed will continue to tighten despite inflation below target

New York Fed President William Dudley spoke at a business roundtable in Plattsburgh, New York, reiterating Fed Chair Janet Yellen’s determination to push forward with interest rate hikes despite inflation below 2%. The Fed will continue to have this stance unless and until economic data weakens significantly. Some thoughts below

First, for some time, I have been making the observation that the Fed’s 2% inflation target is effectively a ceiling, not a target. But now, in a blog post last week, FOMC dissenter Neel Kashkari, head of the Minneapolis Fed, recently acknowledged that Fed officials are aware this viewpoint is now widespread. However, he also said there was a ‘’faith” inside the Fed that inflation would return to its 2% target. Hence the rate hike last week.

But Kashkari believes that the “data” don’t square with this faith regarding inflation – and so he dissented.

For me, deciding whether to raise rates or hold steady came down to a tension between faith and data.

On one hand, intuitively, I am inclined to believe in the logic of the Phillips curve: A tight labor market should lead to competition for workers, which should lead to higher wages. Eventually, firms will have to pass some of those costs on to their customers, which should lead to higher inflation. That makes intuitive sense. That’s the faith part.

On the other hand, unfortunately, the data aren’t supporting this story, with the FOMC coming up short on its inflation target for many years in a row, and now with core inflation actually falling even as the labor market is tightening. If we base our outlook for inflation on these actual data, we shouldn’t have raised rates this week. Instead, we should have waited to see if the recent drop in inflation is transitory to ensure that we are fulfilling our inflation mandate.

When I’m torn between faith and data, I look at decisions from a risk management perspective.

The risk of raising rates too soon is a continuation of the FOMC’s track record of coming up short of our inflation objective. As this Atlanta Fed survey recently indicated, many people already believe that our 2 percent inflation goal is a ceiling rather than a symmetric target. Raising rates will just further strengthen that belief. And if inflation expectations drop, as we’ve seen in some other countries (and there are signs it might be happening here in the United States), it can be very challenging to bring them back up.

Much more here at this link

Bottom Line: Kashkari is an outlier here. People like Dudley are “very confident” this economic expansion has legs. Most Fed officials believe, therefore, that the FOMC has room to normalize policy before a policy error becomes fatal to the US’s economic expansion. They also believe that, given how low unemployment is, inflation will eventually rise. And this “faith” about the medium-term outlook means policy rates will continue to rise for the foreseeable future – until weak data causes the Fed to pause.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He has also been a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.