Janet Yellen's Inflation Problem
Federal Reserve Chair Janet Yellen has been vexed by an inflation problem. Now she is also vexed by an inflation expectations problem. Last week she said (emphasis added):
Uncertainty concerning the outlook for inflation also reflects, in part, uncertainty about the behavior of those inflation expectations that are relevant to price setting. For two decades, inflation has been relatively stable, reacting less persistently than before to temporary factors like a recession or a swing in oil prices. The most convincing explanation for this stability, in my view, is that longer-term inflation expectations have remained quite stable. So it bears noting that some survey measures of longer-term inflation expectations have moved a little lower over the past couple of years, while proxies for these expectations inferred from financial market instruments like inflation-protected securities have moved down more noticeably. It is unclear whether these indicators point to a true decline in those inflation expectations that are relevant for price setting; for example, the financial market measures may reflect changing attitudes toward inflation risk more than actual inflation expectations. But the indicators have moved enough to get my close attention. If inflation expectations really are moving lower, that could call into question whether inflation will move back to 2 percent as quickly as I expect.
Subsequently, the University of Michigan's read on long-run inflation expectations plunged to a series low:Â
Just for reference, consider the behavior of the inflation expectations during the last three tightening cycles:
Spot the odd man out.
This, one would think, should grab Yellen's attention. There is speculation of what this means for this week's FOMC statement. For example see here:
âThe key thing to watch will be whether the Fed changes its language on inflation expectationsâ in the statement it publishes after its meeting, said Neil Dutta, head of U.S. economics at Renaissance Macro Research in New York.
They should change the language, but I don't think the will. The problem is that if the Fed acknowledges serious concern about declining inflation expectations, they have to deal with this line from the FOMC statement:
The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.
It makes no sense to show concern with the possibility of unanchored inflation expectations to the downside while at the same time stating that you anticipate the next policy action will be a hike. If inflation expectations are no longer stable, then any rational central banker must act accordingly, and this this case that means easing policy. Anything else is simply irrational, and the Fed should be called out for it.
Do any of us believe the Fed is about to ease policy?
Chicago Federal Reserve President Charles Evans opened the door to an easier policy stance by offering Evans Rule 2.0: Commit to holding steady on rates until core inflation has reached the Fed's inflation target. But think of how big of a leap that would be for the Fed. The Chair just gave a relatively optimistic outlook for the US economy, reiterating her belief that higher rates were coming. Up until the May employment report (a report that Yellen downplayed), policy makers were falling over each other to put the June meeting in play, pushing the message that was eventually revealed in the minutes of the April meeting. Unemployment is at 4.7 percent, a level generally believed within the Fed as consistent with full employment. Second quarter growth looks to be respectable in the 2.0-2.5 percent range. Financial markets stabilized after a tumultuous first quarter. Oil prices moved higher. In short, there is a reason Fed officials put June into play.
It's hard to see the Fed moving from "we plan to hike rates as early as June" to "rate hikes are off the table until inflation hits 2 percent" in just a few weeks. Moreover, adopting Evans Rule 2.0 would dramatically jack up the odds that the Fed would subsequently need to hit the inflation target from above. But the Fed has shown little willingness to consider anything other than hitting the target from below. A shift to Evans Rule 2.0 would take a sea change of sentiment at the Fed. I don't see it happening in just a few weeks on the basis of essentially one number.
So my expectation is that the Fed does not change its inflation expectations language in this week's FOMC statement. If they do, they have to understand that they market participants will price out rate hikes until 2017. I don't think they want this; I think instead the Fed will be working to keep July in play (a tall order in my opinion).
There is now a natural press conference question to add to my existing list:
Chair Yellen, last week you said that inflation expectations were low enough to be on your radar. Now they have turned even lower, but the FOMC declined to acknowledge the weakness in this FOMC statement. Just how low do inflation expectations need to be before the Fed acts?
I would guess that this is the first question for Yellen.
Bottom Line: It is reasonable to think that the Fed will change their inflation expectations language at this week's FOMC meeting. Completely rational considering Yellen's comment last week. A comment that I suspect she now regrets. But a change to the language requires a policy response I don't think the Fed is ready to make. If I am wrong, if the Fed is much more dovish than recent comments, or the most recent minutes, suggest.
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