Different Economic Indicators Send Mixed Signals to The Fed

By Biagio Raimondi

The unemployment rate is at a 16-year low at 4.3%, according to the Bureau of Labor Statistics but the inflation rates remain underwhelming.


Months before the close of Fed Chair Janet Yellen’s first term she is faced with a unique problem, the likes of which the Federal Open Market Committee has never seen. An unemployment rate of 4.3% provides a strong piece of evidence that our economy is strengthening. But some are concerned that stagnating inflation is proof of an underlying issue. 


   
In the years following the 2008 financial crisis, a low federal funds rate has coaxed the economy back on track. Low rates are meant to stimulate the economy by making borrowing costs less expensive. This leads to more spending by consumers. The economic growth that follows lowers the unemployment rate, raises the inflation rate, and raises GDP (in theory). Only recently has the Fed started to raise their short-term interest rates in fear that if they remain low, the economy will excessively expand.

 

The unemployment rate is at a 16-year low at 4.3%, according to the Bureau of Labor Statistics. This alone will push the Fed to raise the federal funds' rate in the near future, even as early as December. But tepid inflation has plagued the Fed with a difficult decision. If they decide to raise rates, inflation will continue to fall. If they keep rates low, the economy could overheat and potentially halt economic expansion.


Inflation could be remaining stagnant for several different reasons. The first reason is quite simple. If consumers are used to seeing the price of goods and services drop, then they will continue to wait for them to drop further. For example, if the price of computers starts to drop, the normal thing to do would wait until the price stops dropping to buy the computer. This could be one reason that inflation remains low even when purchasing power within consumers is stimulated by low rates.

 

A more widely accepted explanation is that with wage growth continuing to stay depressed, inflation cannot fully rebound. With higher wages comes more spending which will push inflation up. If wage growth remains sluggish we can assume that inflation will too.   


      
In an interview with the Wall Street Journal, Yellen states that it is “premature that the underlying inflation trend is falling well short.” She has remained confident that inflation will rebound regardless of the Fed’s plan to increase rates by the end of the year. But her colleagues are not so certain.


The Federal Reserve Board of Governors had their last meeting in July. According to David Harrison of the Wall Street Journal, the minutes from this meeting “reveal growing concern among some officials that recent soft inflation numbers could be a sign that something has fundamentally changed in the economy.” Officials ended up having a split decision on whether or not a rate hike in December would be prudent. Inflation could rebound before their decision, but nonetheless, this could be viewed as cause for concern.          


The Fed started using monetary policy to influence the economy in the mid-1900’s. In the late 1900’s we had ramped inflation that would be cooled by Fed Chair Paul Volcker. In the early 2000’s we had economic prosperity under Fed Chair Alan Greenspan. During this time inflation was around 2% and we were at full employment. In the years following Greenspan’s tenure, the US economy slipped into a massive recession that included high unemployment and very low inflation.

 

Only recently has the economy shown signs of strength, but inflation statistic has remained underwhelming. In the history of monetary policy, there has never been a time where inflation was dropping below two percent as unemployment was below five percent. In 2004 and 2005, inflation and unemployment dropped simultaneously but both were above their target percentages. Now that both numbers are under their targets and continue to drop, the Fed must operate by the seed of their pants.

 


Every monthly inflation reading will now provide important insight on how the Fed will react to this unique situation. According to a survey conducted by the Wall Street Journal, economists agreed that the Fed would raise its target rate by a quarter percentage point in December but the longer inflation remains low, the more unsure Wall Street becomes off when the next rate hike will happen. The Federal Open Market Committee has four months to make a decision. One that could possibly define Yellen’s tenure as Fed Chair.        
        


Biagio RaimondiComment