Market turbulence? Check? Heightened concerns about economic growth—globally and for the US? Check. Does this mean that the Fed won’t raise interest rates this year? Not necessarily. Or so Fed Chair Janet Yellen intimated in a speech today. A slowdown in China’s growth rate and a mixed bag of numbers for the US lead some (many?) economists to conclude that it’s not a good time to start squeezing monetary policy. But Yellen has a different view. Sure, she may have surprised the crowd with the no-hike decision at last week’s FOMC meeting–a decision that was widely interpreted as the Fed’s way of saying that the future looked a bit dicey. But don’t confuse last week’s Yellen with today’s Janet.
“We do not currently anticipate that the effects of these recent developments on the US economy will prove to be large enough to have a significant effect on the path for policy,” she said. Yellen went on to outline the argument for pressing ahead with a rate hike in the near future even as the macro trend appears to be weakening:
Given the highly uncertain nature of the outlook, one might ask: Why not hold off raising the federal funds rate until the economy has reached full employment and inflation is actually back at 2 percent? The difficulty with this strategy is that monetary policy affects real activity and inflation with a substantial lag. If the FOMC were to delay the start of the policy normalization process for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession. In addition, continuing to hold short-term interest rates near zero well after real activity has returned to normal and headwinds have faded could encourage excessive leverage and other forms of inappropriate risk-taking that might undermine financial stability. For these reasons, the more prudent strategy is to begin tightening in a timely fashion and at a gradual pace, adjusting policy as needed in light of incoming data.
In theory, it all makes perfect sense. But given the current state of economic growth (modest, at best) and inflation (well below the Fed’s 2% target), worrying about the possibility that a sudden series of rate hikes may soon be required to cool an over-heating economy is the monetary equivalent of looking for monsters under the bed.
But inflation’s due to pick up soon, she insists. One reason, according to Yellen, is the public’s firm inflation expectations, which have been more or less stable at around 2%. “The fact that these survey measures appear to have remained anchored at about the same levels that prevailed prior to the recession suggests that, once the economy has returned to full employment (and absent any other shocks), core inflation should return to its pre-recession average level of about 2 percent.”
Ok, but what’s keeping inflation so low–well below the public’s expectations? Weak energy prices and the disinflationary drag from import prices due to a strong dollar. The “basic message,” she concluded:
The current near-zero rate of inflation can mostly be attributed to the temporary effects of falling prices for energy and non-energy imports–[a view that’s] quite plausible. If so, the 12-month change in total PCE prices is likely to rebound to 1-1/2 percent or higher in 2016, barring a further substantial drop in crude oil prices and provided that the dollar does not appreciate noticeably further.
Perhaps, although raising rates based on a forecast of higher inflation while robust disinflation/deflation still dominates around the world may come with a hefty price tag if the prediction turns out to be wrong, or off by a year or two… or ten. What are the chances that Yellen’s expectations are accurate? Let’s answer that by citing the opening line from a recent Wall Street Journal article that was filed as a report about a topical subject at last month’s Fed symposium in Jackson Hole: “Central bankers aren’t sure they understand how inflation works anymore.”