The Federal Reserve's wager on inflation

by Michael Collins, Investment Commentator at Fidelity

April 2016

The Federal Reserve likes to flag its intentions if it can. The US central bank has made it clear that it only expects to conduct two rate increases in 2016, on top of the one in December that boosted the US cash rate from zero to 0.25%.

But something is afoot that threatens the snail’s pace on US rate increases. Inflation is stirring in the US. After spending more than a year below an annual rate of 1% due to falling oil prices, the Fed’s preferred inflation gauge, the personal consumption expenditures price index, rose 1.7% in the 12 months to February, a three-year high. Other measures spew out higher results. Core consumer prices (a gauge that excludes food and energy prices) rose 2.3% in the 12 months to February, the fastest in four years. Core inflation measures produced by the Federal Reserve of Atlanta and the Federal Reserve of Cleveland are rising at close to a 3% annual pace. The Fed’s goal is to keep inflation at 2%.

The Fed signal of only two rate increases in 2016 is thus a gamble. The US economy expanded at a 2.4% pace in 2015 because consumers are spending and the economy is operating around full employment – the jobless rate was at 5% in March. Theory and history suggest inflation will speed up. The danger is that inflation bursts through the Fed’s target and the Fed has to raise rates faster than intended to contain price increases.

Past errors

The US central bank has on numerous occasions allowed inflation to surge by leaving monetary policy too loose. The inflation outbreak of the mid-1960s, which saw inflation breach 4%, was due to the Fed’s misjudging how low it could take the unemployment rate without triggering inflation and to it prioritising full employment over price stability. The double-digit inflation of the 1970s got started when the Fed persisted with an expansionary monetary policy to combat a recession even though inflation was already 6%. The oil shocks that followed fanned inflation; they did not trigger it. Skip forward 25 years and the Fed kept rates too low after the Asia crisis erupted in 1997. At the time, the economy was at full employment and wages growth took off enough to warrant rate increases. After the dotcom bubble burst in 2000 and the terrorist attacks in the US a year later, the Fed kept rates too low and fanned a housing bubble that led to a global financial crisis.

Why is Yellen hesitating when confronted with evidence that inflation is mounting? Yellen sees that there is more spare capacity in the labour market than statistics indicate. Yellen dismisses higher inflation readings as aberrations. She scorns the threat of inflation even though she admits real interest rates are 1.25% below their level where they neither hinder nor help the economy and that fiscal stimulus is positive for the first time in years.

Yellen sees that when interest rates are low the risks for the Fed are asymmetric. She thinks it’s better to let inflation overshoot a touch than risk smothering the economy when the Fed could “provide only a modest degree of additional stimulus” to help it recover.

Yellen appears sanguine about a deliberate overshoot in inflation even though it would cause a political backlash because she is banking on investors pricing in higher bond yields in anticipation of Fed rate increases if evidence of inflation mounts. She describes this de facto tightening in monetary policy as an “automatic stabiliser” because it would slow the economy without policymakers doing anything. Investors can only hope that such an outsourcing of policy-setting helps if the Fed policymaker projections go awry.

Janet Yellen quotes come from her media conference on 16 March 2016, the day of the most recent FOMC meeting – “Transcript of Chair Yellen’s Press Conference March 16, 2016” that can be found at  – and her speech on 29 March 2016 in New York “The outlook, uncertainty, and monetary policy” that can be found at Other financial information comes from Bloomberg unless stated otherwise.

Financial information comes from Bloomberg unless stated otherwise.