Almost 40 years after Paul Volcker brought the US economy to its knees to bring inflation down, Federal Reserve chairman Jerome Powell and his colleagues are on a mission to stoke price pressures and avoid a Japan-like deflationary trap.
Declaring that too-low inflation was “one of the major challenges of our time,’’ Powell left open the possibility on Wednesday that the Fed’s next interest-rate move might be a cut after four increases last year.
The world’s most powerful monetary policy maker also sketched out a harmful scenario in which consumers and companies lose faith in the Fed’s ability to hit its 2% inflation target.
“If inflation expectations are below 2%, they’re always going to be pulling inflation down and we’re going to be paddling upstream’’ to keep prices up, he told reporters after the Fed unexpectedly scrapped its forecast of any rate hikes this year.
That’s the type of situation that Japan fell into two decades ago and with which Europe is flirting now. It’s a path that could ultimately lead to a deflationary downturn as households and businesses put off borrowing and spending today because they’re convinced prices will be lower tomorrow, no matter how far the central bank lowers interest rates.
“We are not getting any inflation and the risk is that we find out – as did Europe and Japan – that we are stuck and that the central bank isn’t able to raise inflation,” said Mark Spindel, chief investment officer at Potomac River Capital in Washington.
The Fed hasn’t hit 2% inflation on a sustained basis since formally adopting that objective in 2012. In December, the personal consumption expenditures price index that the Fed targets rose 1.7% from a year earlier.
The extra yield investors demand to hold 10-year Treasuries over two-year notes was 13 basis points, highlighting market conviction that inflation will stay subdued over the next decade.
“I don’t feel we have kind of convincingly achieved our 2% mandate in a symmetric way,’’ Powell said after the Fed left its benchmark policy rate in a range of 2.25% to 2.5%.
The Fed’s own forecasts highlight the central bank’s dilemma.
Scott Minerd, Guggenheim Partners co-founder, reacts to the decision by the Fed decision.
With the economy running around their estimate of its speed limit for the next three years, and employment beyond their proxy for maximum labour use, policy makers saw little need to lift rates to a level that might slow growth.
“Policy makers appear to have cooled on the notion of any meaningful, lasting impact from last year’s tax reforms and instead project a return to trend growth, a stabilisation of the unemployment rate and little pickup in price pressures. Amid this backdrop, they do not see much need to further normalise interest rates”, says Carl Riccadonna, Yelena Shulyatyeva and Tim Mahedy, US economists.
That’s a marked departure from what they envisaged just three months ago, when they were projecting that they’d hike twice this year and eventually lift policy into restrictive territory as inflation poked above 2%.
“They’re clearly just not confident that inflation is going to move very much,” said William English, a professor at Yale University and former senior Fed economist. “That’s why they’re willing to be so patient” about raising rates.
Powell confessed that there is “no easy answer’’ to explain why price rises have been so subdued. Two possible reasons he cited were that the labour market might not be as tight as policy makers believe or inflation expectations might have slipped lower.
While wage increases are now running “at healthier and higher levels,’’ that has not led companies to raise prices at a faster clip in response, he said.
What’s more, inflation has stayed low even though President Donald Trump’s tax cuts lifted growth to its fastest pace since 2005 last year, on a fourth-quarter-over-fourth-quarter basis, and his trade tariffs have put upward pressure on some import prices.
“This was about as an inflationary environment as you could put together, and it just wasn’t there,’’ said Julia Coronado, president of MacroPolicy Perspectives LLC in New York. With little risk on the price front, Fed officials have now shifted to letting the expansion run, she said.
Powell called the economic outlook “positive’’ though he acknowledged recent data have been mixed.
“Underlying economic fundamentals are still very strong,’’ he said. Unemployment is low, wage growth is picking up, and consumer confidence is high, he added.
The Fed chairman brushed off concerns that the central bank’s shift to an easier stance could spur a stock-market bubble such as occurred in the late 1990s dot-com boom.
“We’re in a very different world today,’’ he said, arguing that the Fed is much more attuned to such risks than it was back then. “We don’t see financial stability vulnerabilities as high,’’ he added. Get ‘Creative’ Powell said the Fed might need to get “more creative’’ in figuring out ways to convince Americans that it’s committed to pegging inflation at 2%.
The central bank has embarked on year-long, wide-ranging review of its strategies, tools and communications practices. Front and centre is what to do about inflation.
While Powell has ruled out increasing the 2% target, he’s raised the possibility that the central bank could adopt a “make-up’’ strategy – letting inflation run above target during good times like now, to offset the periods of slower price rises.
“There is an important change underway whereby the Fed wants to foster a period of inflation modestly above target inflation in order to uphold the credibility of that target,’’ said Michael Feroli, chief US economist at JPMorgan Chase & Co in New York.
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