Federal Reserve consternation about below-target inflation has grown to the point that Chair Janet Yellen calls it a mystery, but for now the policymaking Federal Open Market Committee (FOMC) remains on course for further gradual short-term interest rate hikes.
It would take a lot for the FOMC not to raise the Federal Funds rate in December for a third time this year and the fifth time since it began tightening in December 2015.
The FOMC is even less likely to be diverted from balance sheet normalization now that it is scaling back bond reinvestments and rollovers. As Yellen said after the balance sheet reduction plan was implemented in September, it would take “material deterioration” in the economy to alter or abandon it. The Fed’s first option would be to adjust its primary tool — the funds rate.
There are those who think the funds rate path should be flattened given inflation’s shortfall from the 2% target. Minneapolis Federal Reserve Bank President Neel Kashkari asserts the rate should be held at 1% to 1.25% until that goal has been reached. He derides warnings of inflationary overheating as “ghost stories.”
Governor Lael Brainard counsels, “We should be cautious about tightening policy further until we are confident inflation is on track to achieve our target.” Chicago Fed President Charles Evans wants to “see clear signs of building wage and price pressures before taking the next step in removing accommodation.” He argues, “Maintaining policy accommodation until we are more demonstrably on a sustainable path to 2% is key for reaching that objective, and for maintaining the credibility of our price stability goal.”
Dallas Fed chief Robert Kaplan, who like Brainard and Evans voted for the June rate hike, is “open” to a December rate hike but first wants to “get a grip” on why inflation is so low. But exponents of inaction or greater gradualism remain a minority. Concerns about low inflation are not being dismissed. Yellen acknowledged them in her September press conference and a subsequent speech, saying the FOMC majority’s base case that inflation will rise to 2% over the next couple of years “could be wrong.”
There is growing uncertainty about that prognosis, Yellen conceded. There could be more labor market slack than supposed, even though the FOMC’s 4.6% estimate of the longer run unemployment rate is two tenths higher than the actual rate. “Labor market conditions may not be as tight as they appear to be, and thus they may exert less upward pressure on inflation than anticipated,” she said.
Yellen sounded much less confident in the Fed’s ability to forecast inflation trends. If such forces have altered inflation trends, the Fed might have to reassess its outlook in ways that “would naturally result in a policy path that is somewhat easier than that now anticipated,” she said. Given uncertainty, “We will need to carefully monitor the incoming data and, as warranted, adjust our assessments.”
Though Yellen’s musings are potentially significant, the FOMC’s latest inflation projections are only “slightly softer” and their funds rate projections are “essentially unchanged” as she told reporters. The FOMC dot plot still shows a third rate hike this year and three more next year, moving it to 2.9%, slightly above its downwardly revised 2.8% neutral rate by the end of 2018.
So Yellen’s willingness to reassess inflation shouldn’t be seen as a departure from the FOMC familiar consensus that inflation will “stabilize at around 2% over the medium term.”
The FOMC has other policy considerations. Not only is the economy close to full employment, tax reform may pose upside risks. Financial conditions remain easy, if not worrisome. In the minds of some, the fact that asset prices have largely failed to respond to Fed tightening gives the Fed license to do more — not less.
Too little attention was paid to Yellen’s admonition that “We should also be wary of moving too gradually. ... Without further modest increases in the Federal Funds rate over time, there is a risk that the labor market could eventually become overheated, potentially creating an inflationary problem that might be difficult to overcome without triggering a recession.”
She added, “It would be imprudent to keep monetary policy on hold until inflation is back to 2%.”
There are downside risks too, but one reason the Fed is lifting the funds rate is to give itself room to ease if those risks materialize.
Yellen did say inflation uncertainties “strengthen the case for a gradual pace of adjustments,” but she wasn’t signaling an even more gradual path of funds rate hikes — not yet anyway. She and her fellow policymakers may feel the need to prolong accommodation, but December is probably too soon to decide that.