Fed's long-run miss of inflation goal undermines rate hike case

[WASHINGTON] When Federal Reserve policy makers were debating the adoption of an inflation target five years ago, the hawks pushed for a 1.5 per cent goal as the best way to meet the central bank's price stability mandate.

Then-chair Ben Bernanke and his lieutenant Janet Yellen resisted the arguments of the inflation-phobes, winning agreement for a 2 per cent objective already in vogue at other central banks.

Ms Yellen won that battle but may be losing the war.

Since the Fed established its goal in January 2012, inflation has averaged just 1.3 per cent, held back by the slow pace of the US economic expansion and weaknesses abroad. The risk is that's leading consumers and companies to anticipate a continued shortfall going forward, hindering efforts by now-Fed Chair Yellen and her colleagues to attain their price goal.

"Lower inflation expectations make it all the more difficult for the central bank to achieve its inflation objective," Charles Evans, president of the Chicago Fed, said in remarks posted on the bank's website on July 14.

That, in turn, could undercut the Federal Open Market Committee's plans for further, gradual increases in interest rates, because it's hard to lift inflation - or inflation expectations - while tightening monetary policy.

After raising rates three times in the past three quarters, policy makers penciled in one additional rate hike this year and three more in 2018. They're widely expected to hold rates steady at their next meeting on July 25-26.

Ms Yellen told lawmakers last week that future rate increases are contingent on continued confidence that the Fed will eventually achieve its price goal.

"We're watching this very closely and stand ready to adjust our policy if it appears that the inflation undershoot will be persistent," she said in a July 12 appearance before the House Financial Services Committee.

Expectations matter because they shape how households and companies act and thus can go a long way in determining where inflation actually ends up. Consumers accustomed to meagre inflation will resist paying up for goods and services.

Companies, in turn, will shun giving higher wages to their workers because they fear they'll lose sales if they raise prices to cover added labour costs. It's a vicious circle that it's difficult for monetary policy makers to break.

'Very Aware'

Ms Yellen told the Senate Banking Committee on July 13 that the Fed was "very aware" of the fact that inflation has been running below target for years and was "very focused" on lifting it to 2 per cent. She insisted once again that the Fed was equally adverse to inflation running below or above its objective and that the 2 per cent goal was not a ceiling for policy.

Yet the Fed's persistent undershooting of that target raises doubts in people's minds about how symmetric its goal is, said Narayana Kocherlakota, who was president of the Minneapolis Fed from 2009 to 2015.

"The FOMC has really left itself open to a problem," said Mr Kocherlakota, who now teaches at the University of Rochester and is a columnist for Bloomberg View.

"What really matters to the public is your track record" not what you say.

The clearest sign that inflation expectations have fallen in recent years shows up in the Treasury bond market, where investors are betting the Fed will continue to fall short of its price goal.

Consumers also have marked down their outlook and generally see average annual price gains of roughly 2.5 per cent in future years, according to the University of Michigan's household survey.

That's equivalent to about a 1.5 per cent inflation rate because consumers don't take account of the changes in product quality that government statisticians do, according to Ethan Harris, head of global economics research at Bank of America Merrill Lynch.

Much of the decline in household inflation expectations in the past few years has been due to a drop in the proportion of Americans anticipating annual price rises of 3 per cent or more.

"There's a real risk that inflation expectations have already drifted down and might drift down further," said Dartmouth College professor Andrew Levin, a former aide to Ms Yellen when she was vice-chair.

As for companies, an April survey by the Atlanta Fed found that more of them believe the central bank is willing to tolerate inflation below target than above the objective.

Atlanta Fed research director David Altig said he believes that expectations are anchored at 2 per cent but acknowledged that it was not out of the question that they've slipped lower.

"If someone were inclined to argue that expectations look anchored somewhat below 2 per cent, that case can be made," he said in an interview.

"It's not our benchmark case, but one that is intellectually coherent."

Lower expectations could help explain what some Fed officials see as the recent puzzling performance of inflation, which has fallen, not risen, in recent months, even as the economy has continued to forge ahead.

"I don't think anybody can give a fully satisfactory answer to why we're seeing the inflation trajectory that we see today," Fed governor Lael Brainard said on July 13.

"For my own part, I'm just being very cautious about making sure that our monetary policy settings are orientated to very firmly defending the credibility of our symmetric 2 per cent target."

BLOOMBERG