Inflation, strangely low, holds key to 2014 Fed policy

Tuesday, 14 January 2014 00:01 - - {{hitsCtrl.values.hits}}

REUTERS: Stubbornly weak inflation is shaping up as the wild card for US monetary policy makers this year, with top Federal Reserve officials stumped by why it has lingered so low for so long and at odds as to what to do about it. As the Fed wrestled through last year with deciding when to start trimming its massive bond-buying stimulus, the bulk of attention was focused on the unemployment rate, which until recently has been slow to fall following its spike up to 10% during the recession. By last month, policy makers had grown confident enough in the job market to dial back on the program. Figures released Friday showed the jobless rate fell to a five-year low of 6.7% in December, despite the smallest monthly job gains in three years. With much of the hiring slowdown attributed to bad weather, however, many analysts say the Fed will stay on track with plans to end bond buying by late this year. But there is a hitch: inflation has been drifting down for much of the last two years, measuring a feeble 1.1% in November by the Fed’s preferred gauge.

The longer it lingers well below Fed’s 2% goal, the more at least a few policy makers worry it is a sign that the recovery might not be as strong as it looks. In theory, inflation should rise as the job market heals. “There’s a lot we don’t know about inflation,” said Eric Stein, a portfolio manager for Eaton Vance in Boston. “I think it’s certainly frustrating to them.” Both Boston Fed President Eric Rosengren and Chicago Fed President Charles Evans have referred to stubbornly low inflation as a “puzzle,” and have warned that the longer it persists, the more likely it is that there is something rotten in the state of the economy. “Most people are assuming it’s temporary, but the longer we continue to not see it move back to the 2% goal, the more we have to be concerned that there are things going on that we have not fully incorporated in the model,” Rosengren told Reuters this week. But understand it or not, the inflation data is key. The US Commerce Department’s personal consumption expenditure index of inflation, which the Fed follows closely, is “the critical monthly statistic for analysing Fed policy in 2014,” Pimco’s Bill Gross, manager of the world’s largest bond fund, said in his monthly letter to investors. Outside the measure most closely watched by the Fed, which strips out food and energy costs, there is little evidence of momentum for higher prices, in the United States or elsewhere. The Commerce Department says goods prices through November had fallen for four straight months on a year-over-year basis, and larger-ticket durable goods items were down by nearly 2% from a year earlier, the fastest annual decline in nearly three years. Moreover, recent commentary from US retailers indicated that many relied heavily on discounting to lure shoppers during the recent holiday sales period. And it’s not just a US problem. Euro zone inflation fell unexpectedly in December from the month before, increasing the European Central Bank’s challenge of avoiding deflation as well as supporting the bloc’s recovery. There are “miles to go ... before a policy rate hike,” Gross said, predicting the Fed will only start raising rates in 2016. Janet Yellen, who will take the reins as Fed chief after Ben Bernanke’s term ends 31 January, has been particularly attuned to the threat of too-low inflation, explaining at a 1996 Fed policy-setting meeting that when inflation falls below 2%, “nominal rigidity begins to bite,” pushing up permanent unemployment. A certain amount of inflation, say 2%, is necessary to grease the wheels of the economy and put downward pressure on unemployment, she argued then. As head of the Fed’s communications sub-panel, Yellen helped get the 2% inflation goal enshrined two years ago as an explicit policy aim. To Yellen, high unemployment is simply unacceptable. “Long spells of unemployment are particularly painful for households, impose great hardship and costs on those without work, on the marriages of those who suffer these long unemployment spells, on their families,” Yellen said in her confirmation hearing last year. And that very focus on unemployment, and her recognition that too-low inflation can be a contributing factor, is why “inflation is the key dynamic for Yellen and the Fed this year,” according to Lou Brien, a Chicago-based analyst for DRW Holdings. “The labour market is not unimportant, just less so for their policy decisions.”