The Fed taper hits an inflation hurdle

Stubbornly low inflation and an imminent change of leadership suggest the Federal Reserve may not taper its stimulus program just yet. Despite the obstacles, a Fed taper can't be far away.

As the Federal Reserve meets to debate the merits of tapering its asset purchasing program, low inflation numbers will likely offset encouraging signs of broad-based economic recovery. The change of leadership set to take place early next year could also give the Fed reason to pause.

Consumer price inflation in the United States was largely unchanged in November, to be 1.2 per cent higher over the year. It remains a primary concern for the Federal Reserve as they meet to decide the next step in their US$85 billion per month asset purchasing program.

Over the past couple of months, most of the information coming out of the US has been fairly positive. Despite the 16-day government shutdown in October, non-farm payrolls have continued to rise at a solid pace, the unemployment rate has dropped to 7 per cent, industrial production hit a new peak and consumer spending is showing some signs of sustainability.

While I wouldn’t characterise the US economy as strong, it is stronger, and the resilience shown throughout the government shutdown and its aftermath points to an economy that is capable of a sustainable recovery, even if the Fed pulls back a little on the monetary stimulus.

On that basis the taper could begin immediately, with the Fed set to announce a decision tomorrow morning. But low inflation remains a concern given the Fed’s dual mandate of stable prices (defined as inflation near an upper band of 2 per cent annually) and maximum employment.

Core inflation, which removes volatile items such as food and energy, is up by 1.7 per cent over the year to November. This is more in line with what the Fed would be hoping for.

However, the Fed has a preference for another measure of inflation, the personal consumption expenditure deflator, which is a broader measure of inflation. Growth in that measure has slowed to just 0.7 per cent over the year to October. Core PCE inflation, which again removes volatile items such as food and energy, rose by 1.1 per cent over the year.

PCE inflation is running significantly below other measures of inflation. In addition to core inflation, the Federal Reserve of Cleveland produces a trimmed mean and median measure of inflation (similar to those used by the Reserve Bank of Australia) and these measures suggest inflation is between 1.6 per cent and 2.0 per cent higher over the year.

It is clear that the interpretation of inflation will differ significantly depending on the measure focused on, but I also think that the Fed needs to be more forward-looking when they determine whether to taper.

Inflation expectations remain well anchored at between 1.5 and 2 per cent annually and this will remain the case even if the Fed decides to taper tomorrow or early in 2014. Improving labour markets and capacity utilisation should begin to put a little bit of pressure on prices soon.

Another important factor that may affect the timing of the taper is the changing leadership at the Fed. Next year the Fed will get a new chairwoman, a new vice chair, a new governor and a new president. It may be preferable to allow this new cohort to determine the direction of monetary policy rather than binding them to decisions made now. Presumably, policymakers should consider whether the policy decisions they make today will be consistent with the policy decisions the new group will want in the near future.

I believe that the data justifies the taper beginning tomorrow – albeit a tiny taper – but it is clear that there are obstacles. If the Fed believes that the labour market improvement is sustainable, then they should be confident of acting, with the knowledge that inflation should live up to expectations. If the taper doesn’t happen tomorrow it will still happen soon, of that much I am sure of.