It is all but certain that the Federal Reserve will not make its inflation target this year.
When the Federal Reserve lowered interest rates to zero as an extraordinary stimulus measure to stabilize the economy, it committed to raising them when two conditions were met.
The first condition is when the unemployment rate decreased from 10% to 6.5%. At 5.1%, that goal has been met for a while.
The second condition is when inflation increased to 2%. Since the Financial Crisis, the monthly inflation rate has met or exceed the Fed’s goal a total of 31 times. When the unemployment goal was met in April 2014, the Fed’s dual criteria was met 4 times (April through July in 2014).
Then inflation began to lose momentum. The U.S. has actually had mild deflation this year. The average inflation rate for the first 8 months of 2015 is -0.0116%. That’s right. A negative inflation rate is another way of saying deflation.
The first 5 months of 2015, the U.S. was in deflation (January -0.09%, February -0.03%, March -0.07%, April -0.20%, May -0.04%) though just barely, before turning the corner for the last three months (June 0.12%, July 0.17%, August 0.20%).
The Fed’s plan is to raise rates when the monthly inflation rate heads north but before it hits 2%. Theoretically, gently raising rates will act like pumping the car brakes gently when driving on ice. It is hoped that it will result in gently slowing down inflation so that it can be managed to peak and stay at 2%.
The data does suggest that inflation is gradually increasing but much more gradually than what the Fed would like. Based on the last three months, inflation has been rising on average 0.04% each month. Assume that rate for the last 4 months of the year and inflation rate might increase to 0.36% by year end, which will result in an annualized inflation rate of 0.09%. That is way short of the Fed’s goal. The economy would take a long time to get close to reaching the inflation goal with that trajectory.
There is also nothing to suggest that inflation will speed up. Energy prices are still very low and there is no anticipated catalyst to change U.S. economic growth for the fourth quarter of 2015.
Yet the Federal Reserve continues to state that a rate increase is very much on the table for this year.
To raise interest rates with such low inflation would seriously damage the credibility of the Federal Reserve let alone damage our fragile and modest economic growth. Their credibility took a bit of a hit when they did not raise rates between April and July of 2014. In retrospect, waiting to see if the economy was strong enough was a good call because ultimately, it was not.
But yet to delay a rate increase will increase the magnitude of the negative and unintended consequences from the zero rate policy. The longer rates stay at zero, the more the economy is distorted from the misallocation of capital.
On one hand is loss of credibility and jeopardize the economy. On the other hand, create bigger and harder problems in the future. The Fed is caught between a rock and a hard place, which is exactly where it did not want to be when it started quantitative easing.
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