The market focus was initially on the statement swapping into “can be patient” from “considerable time”. Post the Yellen press conference; markets increasingly focused on no rise in rates before the April 30 / May 1 meeting. Reading through the statement and listening to Yellen's Q&A the market should be focused on the timing of inflation rather than a set schedule from the Fed -- and the Fed's concern about low inflation has risen. From our perspective, inflation is going to stay low for a very very long time, the result from foreign and domestic activity. As such, so too will the funds rates – maybe September for the first move, maybe even later.
Reading through the statement, the reason inflation is running below 2% is now only “partly reflecting declines in energy prices." In addition, market-based measures of inflation compensation have "declined somewhat” (October statement) and then “declined somewhat further” (December statement). The FOMC is realizing a troubling downward trend in inflation expectations this currently being offset only by “survey-based” measures holding onto 2% -- at least for now.
Further along in the statement the FOMC breaks out their view on inflation’s direction. In October they wrote “labor market indicators and inflation [are] moving toward levels . . . .”. This month they drop inflation from the sentence and write that they expect “inflation to rise gradually toward 2 percent as the labor market improves”. Six weeks ago, the “likelihood of inflation running persistently below 2 percent has diminished . . . “
In one sense, dropping the “considerable time” language demanded a dovish policy statement to keep markets from pricing in a more aggressive pace of tightening than what the Fed anticipates at the moment. In another sense, reading through the Fisher and Plosser dissents, Yellen appears to have now firmly taken control of the FOMC and driving policy as she sees fit.
The perspective that the FOMC, Yellen really, is taking, and one we have written about, is that the gap between current GDP and the longer-run GDP trend line is more than large enough to accommodate a very very long period of excessively low interest rates driving down the unemployment rate before inflation shows any signs of bubbling up. The problem with this perspective, as we see it, is not that the inflation argument is wrong but it singles out inflation as the trigger for policy and risks ignoring inflation and distortions not captured by price indexes.
US inflation, in the first order, is no longer wholly domestic event. Imports determine a good part of US inflation and many domestic prices are also restrained because firms can and do source labor and capital from anywhere in the world where it is cost effective to do so. Indeed, the link between the domestic economy and the corporate economy is not nearly as strong as it once was.
As a consequence, running policy by waiting for low unemployment to drive up inflation in the indexes (PCE, the favored measure),is an essentially flawed model. It ignores, as we saw in the 2003-07 period, asset inflation linked to easy credit that can and usually does distort the allocation of capital and, by definition, the economy long before inflation begins to rise.
Targeting credit growth might, in turn, be of more value than inflation. Of late, nominal growth in commercial bank lending has picked up since the Fed stopped pumping up reserves through QE. We are far from arguing that policy rates should be a lot higher today. We are arguing that an inflation target, given the realities of how the US economy operates in this globalized day and age, is a flawed target.
In sum, how we think policy should be run is of little consequence. What matters is what Yellen thinks and she thinks the economy is still a closed system with sufficient population growth, running a huge gap between GDP and potential. As such she will wait for a meaningful upside wiggle to inflation to emerge before taking step one and raise the Federal funds rate. She is probably right on no inflation for a long long time, but wrong on the potential for a damaging impact elsewhere in the economy by keeping rates extraordinarily low while waiting for inflation to rise. Nevertheless, inflation is likely going to stay low and therefore so too will the funds rates – maybe September for the first move, maybe even later.
