How the Fed Sees Inflation

The Fed sees inflation a bit differently than many in the markets do.  In this note I will discuss some of the folk-economics that get talked about casually on the trading floor. I will contrast that with how Janet Yellen has recently described her view of US inflation dynamics (mainly as expressed in her very interesting speech Inflation Dynamics and Monetary Policy).

If you feel like you have a good handle on how inflation works, maybe you should think again.  Macroeconomists in general would not describe inflation as a well-understood problem.  Economist Noah Smith, for example, says baldly that “macroeconomists don’t yet understand how inflation works.”  Despite that chastening counsel, many of us have simple models of inflation that we use.

For example, perhaps inflation is caused by commodity prices.  Roughly, copper gets expensive so wire gets expensive so electronics get expensive so everything gets expensive.  Those of us with memories of the 1970s and the high oil prices are particularly susceptible to this.  And to be sure, in the 1970s inflation and commodity prices did increase together and some economists have found a statistical relationship in that blighted decade.  In the more recent period, however a rise in energy prices in one year will not forecast a rise in inflation in the following year (see this paper by Kansas City Fed economists Todd Clark And Stephen Terry, for example).

Since 1980, however, it is tougher to find a consistent pass-through from commodity prices to broader inflation.  What we actually tend to see is prices of commodities tend to fluctuate widely, and hence CPI tends to move more than core CPI.  But the equation seems to be that the ex-food and energy CPI tends to be more stable than CPI including commodity prices.

Source: Bloomberg

Source: Bloomberg

To be clear, of course if gas prices go up 10% today that will have an impact on today’s inflation.  What is not so obvious before careful investigation is that it will have little direct impact on tomorrows inflation.

Do rising wages forecast changes to inflation?  Like commodity prices, this is an intuitive idea without empirical support in the United States since the 1980s.  A summary of the state of research can be found in The Passthrough of Labor Costs to Price Inflation Peneva and Rudd.  This research undermines the idea of a wage-cost spiral operating recently in the US, and instead suggests the preferred interpretation is high wages are an indicator of a tight labor market.

What does cause inflation?  The prices of inputs to production, especially imports, matter for inflation as does the level of resource utilization.  But, again, this is only for the current level of inflation.  What can we use to forecast tomorrow’s level of inflation?  For the longer trend around which prices fluctuate, however, economists have settled mainly on the idea that one of the most important determinants of inflation is inflation expectations themselves, or more precisely, the difference between realized and expected inflation.  This is called the expectations augmented Philips curve.

In some sense, regressing from inflation to expected inflation does not sound like it solves much. What causes inflation expectations in their turn?  The expectation of inflation expectations?   Nevertheless, this seems to be the best that economist have for the time being.  People make plans and contracts based on some sort of expectation of inflation and when the world does not meet their forecast the adapt in some way.

The great thing about stable inflation expectations is that once you have gotten the expectations to a level you are comfortable with then prices should revert to target as people assume that moves away from the target will be reversed.  The bad news is if expectations are stuck away from the desired level, small deflations tend to move back to the bad level too.  The Fed feels it has built up some credibility by moving expectations to around 2%, the target which was implicit for the second half of the Greenspan years and which because explicit under Bernanke.  I believe a large part of the motivation for the balance sheet expansion (QE) was to take insurance against inflation expectations becoming anchored significantly below 2%.

An important question is whether inflation expectations are indeed well anchored.  Presumably, businesses and consumers extract some sort of trend rate of inflation when making expectations.  A long period of actual inflation away from the target will likely eventually shift inflation expectations.  However, no one knows the parameters of such a function.  The Fed has undershot its 2% target much more than it has overshot it, and its extreme actions to move inflation back to target in the last few years have not been successful to date.  The Fed believes that is because of temporary factors which should wash out over time.  We shall see.  The reality is that actual inflation expectations, however measured, have come down dramatically since the crisis and have not recovered.

Overall, then, the Fed thinks it can solve its inflation mandate by reacting with studied earnestness to sustained tightness in resource utilization because this could lead to the extended bouts of inflation that could shift inflation expectations away from the target.  At the same time they can look though inflation caused by temporary changes in market prices of currencies or commodities, as these do not forecast future levels of inflation.

How does this play into the Fed’s current decision and likely course of hikes?  Here is my interpretation based on closely following what FOMC members are saying: The Fed is raising rates a small amount now so it does not have to raise them a large amount later.  This calculus is all based on keeping inflation expectations well anchored.  The Fed feels resource utilization is tight enough that it needs to ensure the economy does not experience a protracted bout of high inflation.  To that end, it seems to slow growth slightly.  The alternative, in the Fed’s view, is in the medium term there will be a long period of above target inflation which will take a substantial slowdown in the economy to contain.

Source: Bloomberg

Source: Bloomberg

I think it is possible to disagree with this logic. I would likely vote against a hike if I was on the board, but it does make sense.  Given the tepid realized inflation figures over the last fifteen years, it also suggests to me that the Fed will not raise rates much.  My guess is 25 basis points every other meeting for the next year, leaving fed funds at about 1% a year from now.  Note that at that level, real rates would still be negative, and thus the Fed will still be “easing”, though at a reduced level.  I expect Low and Slow to be the watchwords for the Fed in 2016.

[Edited 2015-12-17 to add various links accidentally dropped]

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. The investment return and principal value of an investment will fluctuate and an investor’s equity, when liquidated, may be worth more or less than the original cost. 

October Economic Read

• The most recent readings on the U.S. economy show a moderating pace of growth. Both points are worth emphasizing: the US is still growing but at a slower rate than a few months ago. We see support of this statement in the recent nonfarm payroll and ISM Manufacturing report releases. Even at the more subdued three-month average of 167,000 new jobs a month, we will still be net adding jobs above the number of new workers. Likewise, an ISM Manufacturing reading of 50.2 is below where we have been but still signals expansion (above 50). I believe the source of the slowdown is likely the sharp rise in the trade-weighted value of the dollar over the last several months and, to a lesser extent, weakness in the world economy.
• I see the weakness in the world economy as stemming mainly from the dislocation of global growth due to a lower level and a changing pattern of economic growth in China. It seems there is excess in the global supply structures that were built up to supply raw materials to facilitate the rapidly expanding Chinese infrastructure growth. Presently, it appears the Chinese government wants to shift growth to be more consumer oriented in addition to adapting to a more modest rate of economic growth.
• The chart below shows the year-over-year change in the volume of world trade as measured by the CPB. We can see world trade has been at somewhat lower levels since the global financial crisis and even bearing that fact in mind, the volume of world trade is at low though not crisis levels.

Source: CBP, NBER, Astor Calculations

Source: CBP, NBER, Astor Calculations

• This world trade number is quite thorough, but not as timely as one would like. The chart above is only updated through July. The next chart shows the GDP-weighed purchasing managers indexes of the 20 largest economies for the last few years. This measure looks to have been slowing over the last few months though it does not look like an emergency.

Source: Bloomberg, Markit, Astor calculations.

Source: Bloomberg, Markit, Astor calculations.

• The Federal Reserve refrained from tightening in September though they made a special point to say October 28 is a live meeting, that is saying one in which the FOMC may raise rates. We can be sure there will be a deluge of Halloween related headlines before the meeting. Should we be braced for something more serious? As far as the market is concerned, the FOMC may as well play cards this month as almost no one believes they will raise rates. This belief is because the committee said it is waiting for further labor market strength, but we will not get any additional labor market information before the meeting.
• The Fed is also looking for a conviction that inflation will be heading toward its 2% target in the medium term. How is that side of the Fed’s dual mandate going? The chart below shows three different five year ahead inflation forecasts: the blue and green lines are derived from market prices and the red line is from the Philadelphia Fed’s Survey of Professional Forecasters.

Source: Bloomberg, Federal Reserve Bank of Philadelphia

Source: Bloomberg, Federal Reserve Bank of Philadelphia

• The market based forecasts show marked deterioration this year while the survey has held steady the last few months, though somewhat lower than last year. Various Fed officials have said they are looking through the market measures of inflation somewhat, thinking they may be artificially depressed due to temporary factors. A policy maker with a strong bias toward hiking might be able to square that desire that with current inflation forecasts, but I think holding off would be more appropriate.
• Overall, this last month’s data has made us a bit more cautious on the economy, though we do see continued expansion in the U.S. as the most likely scenario.

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. The investment return and principal value of an investment will fluctuate and an investor’s equity, when liquidated, may be worth more or less than the original cost. 310151-305

Is the economy returning to moderation?

I heard a comment at the Volatility Institute’s annual conference last week which made me want to do a little digging. Charles Himmelberg of Goldman Sachs wondered aloud if the US is returning to what economists call the Great Moderation. This is period of a fairly stable economy as measured by the volatility of macroeconomic variables starting in the 1990s.


I general I think reduced uncertainly about the likely evolution of the economy is a good thing as it allows businesses and households to plan for the future, take the risk of new ventures and to hold lower levels of precautionary savings. There is a sort of unburnt scrub theory of finance drawn on analogy to forest fires. If the rangers run and put out every little forest fire as soon as smoke is sighted, then fuel builds up and the fire which eventually comes is devastating. In the economy, it could be the case that long periods of low volatility could make the eventual shock even more devastating.


The chart below shows the 5 year standard deviation of output, employment and inflation. On this chart, the volatility of CPI, Employment and GDP all look substantially lower in 1990 – 2005 than 1970-1990. To some extent how you answer the question about a renewed period of moderation will be based on where you think the economy is in relation to the Great Recession. If you consider us still in the grip of post crisis aftershocks, then no number crunching is likely to convince you.



Source: Federal Reserve Bank of St. Louis, Astor calculations.


To me, however, it looks like Mr. Himmelberg is onto something. I see volatility of the most important macro variables returning (for now!) to their low 1990-2005 levels. I am not drawing a sharp lesson from this, I highlight it only because I had not quite realized the extent to which the this aspect of economy has returned to pre-crisis patterns.

New directions for the Fed in 2015

The big decision for the Fed next year will be if they should start raising interest rates. Remember that the fed is charged to try to maintain price stability and full employment. This chart shows unemployment and inflation along with the Fed’s inflation target (in blue) and the unemployment rate consistent with stable prices (in pink). The economy has improved without inflation over the last five years.


The argument for raising rates is that it is necessary to control inflation.  This this post from The Economist for example.  I disagree for a few reasons:

  • As the chart below shows, over the last 20 years actual inflation has spent a good deal of time below a band around 2% inflation except and only brief episodes above, suggesting that the Fed is too hawkish on average.


  • There is mounting evidence (for example this note published by the Fed) that the recessions, the possible outcome for raising rates prematurely, can involve permanent reductions in the level of output. Simply put, if you have a million people working for a year they make a certain amount of stuff. If there is a recession and they are out of work, they don’t make up all of the lost output once the economy recovers. To take this risk the threat to price stability must be substantial.
  • Finally, inflation expectations (based on surveys or derived from market prices) remain stable.

Of course, what I think doesn’t matter, only the opinions of the voting members of the FOMC count. Every year a shifting cast of regional presidents serve as voting members on the FOMC. This year sees 4 new presidents along with the chair of the NY Fed who is always a voting member in deference to that bank’s constant connection with the markets. We have two members I would characterize as patient about raising rates and two who seem eager

  • Richmond Fed’s Jeffrey Lacker says that “the unemployment rate is an accurate gauge of labor underutilization. ” Suggesting that rates can rise soon.       Interestingly, he not only expects to raise rates, he wants the Fed to sell securities held under quantitative easing, not just cease to purchase. “I believe the Fed’s efforts to normalize monetary policy must include the sale of mortgage-backed securities in order to reduce the Fed’s role in credit allocation. ” Lacker speech
  • Similarly, the San Francisco Fed’s Williams says “Rate hike likely by mid-2015” Williams speech
  • On the other hand Chicago’s Charles Evans sees risks to tightening: “I am concerned about the possibility that inflation will not return to our 2 percent PCE target within a reasonable period of time.” And he emphasizes caution: “As I think about the process of normalizing policy, I conclude that today’s risk-management calculus says we should err on the side of patience in removing highly accommodative policy.” Evans speech
  • At the Federal Reserve bank of Atlanta Dennis Lockhart believes the United States will approach conditions consistent with full employment by late 2016 or early 2017 and in his view undershoot of the inflation target is currently a bigger risk than overshoot. Lockhart speech
  • The New York Fed president William Dudley seems to be willing but not eager to raise rates next year: “The consensus view is that lift-off will take place around the middle of next year.  That seems like a reasonable view to me.   But, again, it is just a forecast.  What we do will depend on the flow of economic news and how that affects the economic outlook” Dudley speech

Incidentally, NY Fed President Dudley says

In assessing inflation expectations, I currently put more weight on survey-based measures of inflation expectations as opposed to market-based measures.  Survey-based measures have been generally stable, consistent with inflation expectations remaining well-anchored.  However, market-based measures, such as those based on breakeven inflation derived from the difference between yields on nominal versus Treasury Inflation-Protected Securities (TIPS), have registered declines over the past few months, even on a 5-years forward basis.  Research done by my staff suggests that much of this decline in market-based measures of inflation compensation reflects a fall in the inflation risk premium—that is, what investors are willing to pay to protect themselves against inflation risk.  Adjusting for the fall in the inflation risk premium, inflation expectations appear to have declined much less than implied by TIPS inflation breakeven measures.

If he is using this as a reason to raise rates, I cannot agree. First of all, surely a decline in inflation risk premiums means that the market is less concerned about sudden jumps in inflation. That is, the market is telling you that the market is not worried about inflation. I am not sure why a policymaker would want to discount that. Second, it is not clear that Survey based inflation expectations are indeed stable. See this chart of expectations for next year from the Consensus Economics survey.


Whatever is ahead, our next landmark is the final FOMC meeting of 2014 which will feature new forecasts from the committee members and a Janet Yellen press conference on December 17. Hopefully we will get more insight into the Fed’s plans then. In the meantime it is worth noting that for Fed Funds to get to what the median member expects of about 1% by the end of 2015 and they proceed in bite-sized 0.25% steps, they will need to start raising rates in their fifth meeting of the year in July. Given the Fed’s reluctance to surprise the markets, I would expect clear warnings at the March press conference at the latest.

Interestingly, the Fed Fund futures seem to expect less easing overall with year-end 2015 rates in the market at 0.5% which implies starting later or not raising rates at every meeting after they start.

Fed Watch – Jackson Hole

The Kansas City Fed is hosting its annual Jackson Hole conference this weekend (motto: “interrupting Wall Street vacations since 1978”) . Several times in the last few years we have gotten a good preview of the Fed’s concerns for the year ahead by listening to the Chair’s speech. The last two rounds of Quantitative Easing, for example, were foreshadowed by Chair Bernanke’s talks.

The detailed agenda has not been announced yet (watch this space) but it may again be worth taking a day off the beach as the theme of the conference is “Re-Evaluating Labor Market Dynamics” and Janet Yellen’s speech is titled simply “Labor Markets.”

This is timely as one of the most important economic questions of the day is how much slack is truly remaining in the labor market. My forecast, along with many other Fed watchers, is that Yellen will make a point of emphasizing the slack remaining in the labor market.

While the unemployment rate is approaching more normal levels digging deeper we do find evidence of slack beyond the unemployment rate. The number of involuntary part time workers, which I noted in this post, is very high, perhaps three million above typical levels. In addition, the lake wage gains above the level of inflation indicates that despite record corporate profits, employers are not finding it necessary to compete on price. The labor participation rate is more complicated. A large number of people have dropped out of the labor force since the recession though a mixture of the median American getting older and through the difficulty the long-term unemployed have in getting a new job. These contending forces are examined in an interesting report by the Council of Economic Advisors find that about half of the reduction in the labor force is due to aging and about half due to other factors we might hope to be reversed.

Against these indicators of slack what do we see when we look for tightness? I noted the improvement in the unemployment rate above and referring again to my post from July, the quit rate and the job opening rate are both looking as good as they have since the recession and about as good as they did during the last recovery.

Where does that leave the Fed? We can look at the Fed Dual Mandate Report Card below. The X axis show the unemployment rate (with the Fed’s estimate of long run unemployment in pink) and the Y axis shows five-year-ahead expected inflation (with the Fed’s 2% target plus an error band in blue). The details are explained in my post Janet Yellen’s Report Card.



My interpretation of this chart is that the Fed is in the happy situation when its two mandated goals (price stability and full employment) are not in conflict so there should not be a reason to raise rates any time soon.

In thinking about what the Fed will do in the future we need to bear in mind that by law they are mandated to try and manage both inflation and employment. My sense is that Yellen and most of the FOMC see today’s balance of risks tilted toward problems of employment and will let inflation expectations drift somewhat above their target. This may be a change in tolerances from what many of us are used to from the Fed policy in the 1990-2007 period, as economist Tim Duy writes: “Yellen can point out that since the disinflation of the early 90’s, the Fed has not faced an inflation problem, but instead has struggled with three recessions. This on the surface suggests that monetary policy has erred in being too tight on average.” I hope Chair Yellen will give us some clarification and some arguments to shape the discussion.

Janet Yellen’s Report Card

Listening to FOMC Janet Yellen’s press conference last week, we were struck by the same comment that the always-insightful Gavyn Davies noticed:

When we see some conflict between achieving the two objectives …we would consider … just how far we are from achieving each of the objectives and if the distance from achieving an objective is particularly large, it would be consistent with the balanced approach that we would tolerate some movement in the opposite direction on the other objective.

The Fed, by statute, has two explicit jobs it needs to balance: price stability and full employment, with no guidance from Congress about how to define or weigh those goals. This is in contrast to most other central banks which typically only have an inflation mandate.

What to do? Well, under Chairman Bernanke the Fed choose to define price stability as 2% year over year inflation as measured by the Personal Consumption Expenditure Deflator, a slightly different index than the more familiar CPI. The FOMC also polls its members as to the likely long run unemployment range. Given that the Fed assumes that inflation is exactly on target in the long run, this is relevant unemployment rate. As of June 2014 the FOMC saw the long run tendency for unemployment at 5.2 -5.5%, the projections can be found here.

The chart below shows the recent evolution of the Fed’s objectives since 2010 along with the long run targets. The pink band is the long run unemployment rate as of the FOMC, the blue band is the Fed’s inflation target +/- a 0.25% band. The Fed should try to adjust monetary policy with a goal of getting closer to the intersection of the two bands, bearing in mind of course that there is no long run inflation / unemployment trade off.


The central insight provided by this chart is that there is no conflict in the Fed’s two mandates: inflation and employment are both below target and the fed has no need to raise rates soon.

But the Fed will use its expectations as to how inflation is likely to evolve rather than driving by looking in the rear view mirror. We cannot get inside the heads of the Board, but the Cleveland Fed does put together an interesting series of expected inflation based on professional forecaster surveys and manipulations of some market prices. Our scorecard chart is repeated below, but with inflation expectations on the Y-axis. We can see on this chart inflation expectations over the next 5 years are running slightly below the Fed’s long term target. So on this measure as well we expect the Fed to have substantial room to allow keep rates low.


Returning to Janet Yellen’s quote above, it is possible that even if inflation or inflation expectations drift above their target, if the unemployment rate is still 1 percent above its long term level, the Fed may be slow to cut rates.

Bottom line: the Fed is not behind the curve on inflation and will not tighten any time soon absent evidence of increased inflation. Janet Yellen gets a passing grade.