The Federal Reserve has postponed a plan to raise interest rates for the third time this year to offset the impact the economy will feel when they begin to sell off $4.5 trillion of long-term bonds. The problem is that the two closely monitored economic indicators, inflation and unemployment, are sending conflicting messages regarding the urgency of the next hike.
The question of the day is: “Why isn’t inflation increasing as the labor market stabilizes?” The fact that the rate continues to hover at 1.5% instead of moving toward the target of 2% is causing Janet Yellen and other members of the Board of Governors of the Federal Reserve System to scratch their heads in confusion. Come on; everyone knows that as the labor market stabilizes, inflation should go up, right? Moreover, what is the big deal if it does not?
The Wall Street Journal reported on Wednesday:
“Ms. Yellen’s worldview assumes that when unemployment is this low—4.4% in August—inflation should move up to the Fed’s target of 2%. Instead, it may have stabilized around 1.5%. That presents the Fed with some unpalatable options: deliberately overheat the economy for years to get inflation back up, then potentially induce a recession to stop it from overshooting; or give up on the 2% target, which could hobble its ability to combat future recessions.”
IS 2% INFLATION TARGET ACCURATE?
Is the inflation percentage too low and should we expect it to reach the Fed’s target of 2%? Perhaps it’s more important to ask if that’s an accurate expectation. According to the model used to determine the target, the Philips Curve, inflation edges lower when unemployment is above its natural, equilibrium level and putting downward
pressure on prices and wages. Below that natural rate known as full employment, inflation crawls higher. However, many MBA programs now deem the model outdated; over time, trends show it simply doesn’t work.
Why are they so set on 2%? Most financial analysts will tell you a range, and not a finite percentage, should be used to predict a trend, as it gives a margin of error for unexpected movements. In this case, 1.5% might fall within an expected band and be an acceptable target.
UNEMPLOYMENT AND CONSUMER DEBT IMPACT DECISION
While the labor market is showing slow stabilization, most experts agree on underemployment, and discouraged job seekers who are no longer looking keeps the rate artificially low. This means the indicators might not be as out of sync as they appear.
Last month on Liberty Nation, I reported that consumer debt was at an all-time high and that economic expansion has become increasingly dependent on credit. Therefore, any slowdown in borrowing would have a dampening effect on GDP. Raising rates discourages borrowing, and hence may slow growth.
Federal Reserve Bank of Philadelphia President Patrick Harker recently supported holding back on raising its benchmark interest rate for the third time this year. Furthermore, he is in favor of beginning the sale of assets to see how the market reacts before deciding on a move. It seems other members agree and have settled in on letting more time pass in case the inflation marker moves closer to 2%. If it does not move, the Fed will have to admit they missed the mark, which will go more unnoticed by the American people that another interest rate hike.
