A tonic for inflation palpitations
Four years after the US Fed cut rates to zero, misguided inflation fears still linger. But worry warts can rest easy: the economy will need to grow much stronger before inflation is an issue.
These prognostications, like the seemingly annual predictions that the world will end, are wrong. They take little account of the current structure of the US economy which is in no way conducive to higher inflation despite the fact that economic policy is the most stimulatory it has ever been.
Indeed, the current problems in the US economy are more deflationary than inflationary for the simple reason the economy is struggling to get traction out of the mire of a banking crisis, personal wealth destruction from a crash in house prices and a very weak labour market. These reasons are why the risk of an inflation break remains not much different to the prediction of the end of the world some time this week.
With yesterday marking the four-year anniversary of the US Federal Reserve’s decision to cut interest rates to near zero and last week seeing the Fed deciding to ramp up its QE to $US85 billion a month, inflation remains remarkably benign.
When Federal Reserve chairman Ben Bernanke last week reiterated his view that "longer-term inflation expectations continue to be well anchored,” he was correct.
In the US, the consumer price index actually fell 0.3 per cent in November, registering the largest monthly fall since the depths of the recession in 2008. In the year to November, the CPI rose a tepid 1.8 per cent. The core CPI, which is the inflation rate excluding food and energy price changes, rose 0.1 per cent in the month for an annual rise of 1.9 per cent. The annual rise in the core CPI has not been above 2.5 per cent for around 15 years, to further confirm Bernanke’s views.
Viewed another way, the inflation data are consistent with an economy with huge amounts of spare capacity, a below trend growth pulse and in need of ongoing stimulus. As has been clear for some time now, the super-easy monetary policy will be in place until the economy lifts to a point that the growth pick up eats away at this spare capacity.
Four years ago, when the Fed shocked global markets with its move to cut interest rates to near zero, the Federal Open Markets Committee said that it "will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.”
It went on at that time to say "the focus of the committee's policy going forward will be to support the functioning of financial markets and stimulate the economy… the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The committee is also evaluating the potential benefits of purchasing longer-term Treasury securities”.
Fast forward to now and the policy approach from the Fed is little changed, despite three years of economic growth and a moderate decline in the unemployment rate.
The Fed knows that the current recovery is sub-par and growth could almost double from the current 2.5 per cent pace for several years before the output gap is closed. It also knows that with annual wages growth running near a 50-year low – around 1.5 per cent – and with commodity prices crab-walking sideways at moderate levels, there is no present danger to its inflation objective.
For those who still harbour concerns about an inflation break out, there seems little doubt that if or when inflation pressures emerge, it will only be because the economy is truly sustaining a strong rate of growth, that labour market conditions are genuinely tightening and that bank credit is again flowing freely.
The thing the inflation worry warts need to recall is that these outcomes are the current objective of policy. Just last week, the Fed highlighted that its policy settings "seek to foster maximum employment and price stability. The committee remains concerned that, without sufficient policy accommodation, economic growth might not be strong enough to generate sustained improvement in labour market conditions.”
In other words, the economy needs to do a lot of growing before inflation is a concern.
The inflation ideologues should rest assured that the Fed has not taken its eyes of the inflation objectives, as it concluded its statement last week noting, "When the committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 per cent.”
For the moment, the economy is so far short of "maximum employment” with the current easy monetary policy is likely to be around for several more years simply because inflation will continue to run at very low levels.