Last week, headlines and pundits were hot and bothered about the potential for the Federal Reserve to fall behind the curve on inflation. While my on-going assumption is that the Fed will indeed chose much higher inflation rather than risk ending the economic recovery with higher rates, I think the current hand-wringing by some is premature. In fact, it seems more the result of either boredom with the Fed’s business as usual policy stance and/or the anxiety on the part of some stock market bears looking for any kind of catalyst to shake the market out of its low volatility slumber.
I was so surprised at all the hand-wringing over a “business as usual” policy statement that I rolled the tape on the press conference. I was wondering what I missed, I actually listened to the conference call a second time (yes, it was painful). The experience made me even more convinced the market over-reacted just as much as it did when Yellen carelessly suggested rates might increase earlier than the late 2015 market projection.
Recent inflation numbers apparently increased expectations that the Fed might show a more hawkish tone. This is reflected best in the first question of the press conference from Steve Liesman of CNBC:
“Is every reason to expect, Madam Chair, that the PCE inflation rate, which is followed by the Fed, looks likely to exceed your 2016 consensus forecast next week? Does this suggest that the Federal Reserve is behind the curve on inflation? And what tolerance is there for higher inflation at the Federal Reserve? And if it’s above the 2 percent target, then how is that not kind of blowing through a target the same way you blew through the six and a half percent unemployment target in that they become these soft targets?”
This was a leading question, especially considering that Yellen made it very plain in her introduction that the inflation readings remain benign. Moreover, long-term expectations for inflation remain tame (also see the Fed’s latest projections). Most importantly, the year-over-year change in the PCE, the Personal Consumption Expenditure, reached the 2.0% target in early 2012 only to quickly plunge from there. Not only might it be premature to project a 2% reading for next week’s release, but there is nothing to suggest that this time is different. The Federal Reserve has the least control over the non-core prices of food and energy, so the escalation of violence and turmoil in Iraq is definitely not the kind of event that the Fed would try to offset with monetary policy.
The Fed still can’t tease the market into sustaining pre-recession inflation levels…
Source: St. Louis Federal Reserve
Perhap’s Yellen’s poor response ignited the flames of disappointment. Yellen did not address PCE directly and instead talked about the noise in the Consumer Price Index (CPI) while reiterating the Fed’s standard guidance on inflation:
“So, I think recent readings on, for example, the CPI index have been a bit on the high side, but I think it’s–the data that we’re seeing is noisy. I think it’s important to remember that broadly speaking, inflation is evolving in line with the committee’s expectations. The committee it has expected a gradual return in inflation toward its 2 percent objective. And I think the recent evidence we have seen, abstracting from the noise, suggests that we are moving back gradually over time toward our 2 percent objective and I see things roughly in line with where we expected inflation to be.”
Ironically, Yellen could have just pointed to the longer-term trend in the CPI. This view dominates any shorter-term noise….
The overall trend on CPI continues to point downward
Source: St. Louis Federal Reserve
The most bizarre part of the buzz on the Fed’s supposed willingness to ignore inflation is that Yellen re-affirmed, re-emphasized that the Fed is all about meeting its price target. It will not tolerate deviations in EITHER direction for long:
“…we would not willingly see a prolonged period in which inflation persistently runs below our objective or above our objective and that remains true. So that hasn’t changed at all in terms of the committee’s tolerance for permanent deviations from our objective.”
This was Yellen’s response to Liesman asking about the Fed’s tolerance for higher-than-target inflation.
I feel irony in my skepticism about a Fed ignoring a budding inflation threat: this is the core scenario that has kept me long-term in the gold (GLD) and silver (SLV) trades. My thesis/assumption back in 2009/2010 was that the Federal Reserve would be extremely reluctant to tighten policy even as the economy strengthened out of fear that rate hikes would quickly kill the economy. By the time the Fed was ready to hike rates, the “inflation genie” would already be out the bottle. Granted, I am not nearly as rabid about this view, especially since I have come to appreciate the deep entrenchment of the lingering post-recession deflationist psychology in the economy.
So, overall, I am very skeptical that this episode is the long-awaited lift-off of inflation and a lagging Fed. I actually think the Fed is right to look through the current “warming” in inflation readings, and I think it will find vindication just as the Bank of England did during a similar episode under former Governor Mervyn King. When the Fed asks “what inflation”, I find myself surprisingly agreeing for now…
To me, the data do not support the notion that broad-based inflation is taking hold in the economy. We do not even have wage pressures, not to mention all the slack that remains in the economy as evidenced in part by extremely low levels of housing production. Just do a web search or read mainstream financial magazines to see anecdotally how many people are still worried about the sustainability of the so far very weak housing recovery. I find it hard to believe we will get strong inflation with all this weakness and deflationary fears. On the commodity side, copper and iron ore have experienced major price declines in recent months that also fly in the face of any kind of sustained inflationary pressure in the economy.
Full disclosure: long GLD, SLV.
Housing prices are on the march again across the globe, and the International Monetary Fund (IMF) is concerned. In response, the IMF has launched a site it calls the “Global Housing Watch.”
Here is the introduction:
“Housing is an essential sector of every country’s economy, but it has also been a source of instability for financial institutions and countries. Understanding the drivers of house price cycles, and how to moderate these cycles, is important for economic stability.
The new indicators are an important step in assembling country-level data on housing trends in one location, allowing for more transparent cross-country and historical comparisons. The hope is to prompt actions by policymakers to moderate housing cycles.”
Housing has been a natural beneficiary of loose monetary policies. The irony or dilemma in extremely expensive countries like the United Kingdom, Canada, France, and Australia is that overall inflation readings are low. Accordingly central banks are maintaining extremely accomodative monetary policies in these countries. Thus, the traditional brakes for the housing market, higher rates and tighter monetary policy, are absent and nowhere on the horizon. It is no accident that the Bank of Canada and the Bank of England are now talking more loudly about using macroprudential policies to contain housing markets and enforce standard of financial stability. Here are the related recommendations coming from the IMF:
“We do have a set of policy tools that can help – sometimes these are referred to as “Mip-Map-Mop.” Microprudential (Mip) policies look at an individual bank’s balance sheet, for example to determine if it is making too many real estate loans. But it could be that the individual banks are doing what seems healthy for them, but what the banking system as a whole is doing needs results in an unhealthy growth in lending.
So, in addition, macroprudential regulations (Map), operating at the level of the financial sector as a whole, come into play. The most commonly used measures cap how much individuals may borrow relative to their income. These prudential measures are being increasingly used by countries to prevent an unsustainable build-up in debt.
Finally, there is the monetary policy (Mop) that involves the central bank raising interest rates if they want to cool off the housing sector. This can be tricky, because sometimes the economy is weak but the housing sector is booming, and raising the interest rate can harm the overall economy.
So, basically, we need to share experience across countries, to look at trends, use our judgment, and apply policies that that may help prevent problems in the housing sector.””
I will be keeping an eye on this website and the twitter hastag #HousingWatch. I expect some revealing and fascinating data to flow through here. Here are the charts posted on the site showing the relative valuations of housing across the globe. I highly encourage the reader to go directly to the website and browse for yourself. I also hope to write some pieces covering the housing markets in the UK, Canada, and Australia in particular in coming weeks and months.
Note well that the U.S. is NOT in bubble territory (in the aggregate)….