In September, U.S. Federal Reserve Chair Janet Yellen announced a stay of the federal funds rate at a range of one to 1.25 per cent. In her address, Yellen finally conceded the ‘mystery’ of this year’s lower than expected inflation figures, saying, ‘I will not say that the committee clearly understands what the causes are.’
Few could have predicted that, after seven years of an expansionist monetary policy of near-zero interest rates and a massive $4.5 trillion balance sheet, that inflation would be found drifting breezily below its two per cent target. In fact, the Federal Reserve’s (Fed) preferred measure of inflation, currently at 1.4 per cent has been below target for most of the last five years.
In the near-term, this may be worrisome for two reasons: firstly, a central bank that cannot consistently hit its target does not, in principle, make for a very credible bank. If inflation expectations of business and households become less anchored to the central bank’s target, inflation itself becomes more fickle. Secondly, the effect of raising interest rates on prices is not entirely clear. Keep interest rates low, and inflation might suddenly skyrocket due to increased borrowing and overzealous growth, forcing the central bank to raise rates more aggressively in the future and risk tilting the economy into recession. On the other hand, raising rates too high or too fast may quash the long-awaited recovery from the Financial Crisis. Inflation is a worry, but if there’s one thing that’s worse than inflation, it’s deflation. This proves problematic as, in economies where prices are decreasing, people are more likely to save due to the decreasing value of money. This causes a decreased demand for goods, reduced prices and low economic growth-acting in essentially a self-fulfilling cycle.
So, what exactly is happening with inflation?
The Phillips Curve derives from an empirical observation about the inverse relationship between inflation and unemployment. When the economy is booming, unemployment is low, and inflation is relatively high. When the economy contracts, unemployment goes up, and inflation goes down. Given the stubbornly low inflation rate, we would expect the economy to be relatively weak. But the U.S. unemployment rate sits at 4.4 per cent, only modestly below the Fed’s projections of its longer-run normal level. The last time it was that low was in 2007 when interest rates averaged around five per cent. It appears the Phillips Curve is all in a tangle.
Yellen has chalked up previous years’ low inflation figures to temporary phenomena, such as large reductions in energy prices, the large appreciation of the U.S. dollar and slack in the labour market. None of these were significant factors this year – nevertheless, Yellen maintains that the unexpected low inflation is the end, is transitory and she believes that the tightening labour market will eventually push prices up. This is because firms raise wages and consequently prices, to compete for labour.
In contrast, Governor of the Bank of England Mark Carney warned of more permanent forces pushing prices down in a speech at the IMF. He points to growing contestability in global markets and technological change as factors that are deepening trend disinflation in developed economies, including Australia. External demand (demand from the rest of the world) will have greater influence over price-setting behaviour domestically. Conversely, cheap imports make prices intransigent. These forces are hard to control and present a more complex problem to monetary policy-makers tasked with balancing inflation and unemployment.
The ‘gig economy’ – an economy where participants are paid to complete tasks rather than as full-time employees (think Uber) – provides an alternative explanation for the low unemployment, low inflation environment. The high flexibility of labour afforded to employers allows them to hire more people while simultaneously keeping wages relatively low. Meanwhile, economist Larry Summers thinks secular stagnation has something to do with it – a combination of slowing technological growth and an ageing population prompts firms to save excessively, leading to weak demand, weak growth and subdued inflation.
If the forces pushing inflation down are indeed long-term, then the existing monetary framework may need revisiting. For example, some economists have suggested a downward revision of the inflation rate target. This would allow the Fed to normalise interest rates more quickly and mitigate the risks of an overheated economy. This would hedge against firms and households taking excessive risks in the low-interest rate environment, however, may have the unintended effect of leaving the economy uncomfortably close to deflation.
The end of the extraordinary?
In her address, Yellen also finally began the long process of reversing the Fed’s controversial policy of quantitative easing, which describes an unconventional measure involving massive asset purchases to pump money into the economy and stimulate demand. If the measures the Fed took to bring in the global economy from the brink was extraordinary, then the act of unwinding the resultant trillion-dollar balance sheet must surely be a trepidatious affair. And many economists believe that the longer-run neutral interest rate, which is the level of interest rate that is neither expansionary nor contractionary, has lowered since the GFC. This means that in the event of an economic crisis, the Fed will have less of a buffer to reduce interest rates than it did pre-GFC before hitting the so-called ‘zero-lower bound.’ Once interest rates are zero, the Fed cannot stimulate the economy any further with conventional interest rate policy. As Yellen herself suggests, it’s not unforeseeable that the Fed might again have to resort to massive asset purchases to prop up the economy. The extraordinary may yet be the ordinary.
Yellen has been meticulous in preparing the economy for normalisation, signalling gradual rate hikes over the next couple of years. But her stolid approach may be upended in as little as four months’ time when Donald Trump will have the chance to appoint a new Fed Chair, as well as three other already-vacated seats on the Board of Governors. Uncertainty hangs in the air. Meanwhile, U.S. stock markets remain unabashedly bullish, and the economic tea-leaves remain as inscrutable as ever.