The Federal Reserve's wager on inflation

by Michael Collins, Investment Commentator at Fidelity

April 2016

Four times a year the Federal Reserve releases a “summary of economic projections”, which gathers predictions from its 17 policy-setting board members including their forecasts for the federal funds or US cash rate. These projections are shown in a table as a median.[1]

The most recent projections, released on March 16 when the policy-setting board met and left the cash rate unchanged at 0.25%, showed the median forecast for the US cash rate in 2016 had dropped by 50 basis points from December. Fed watchers said this decline in the median forecast from 1.4% to 0.9% indicated that the Fed would conduct two fewer-than-expected rate increases in 2016.

Fed statements that day in March suggested a go-slow on raising the cash rate from the quarter point at which it has sat since the rate was lifted from zero in December. Policymakers said they voted to keep rates on hold in March because other major economies (read China) and financial-market gyrations “pose risks” to the US economy.[2]

Investors were relieved by the Fed’s decision. Higher US rates could slow the US economy and they sap at the world economy. They are a global impediment because they boost the US dollar by attracting capital to the US and thus undermine commodity prices; they form a double-bang to repayments for the US-dollar-indebted emerging world; and they cause turbulence on financial markets.

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 and faster than Fed policymakers expected prices to rise in December. 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.[3] The largest price increases are for everyday stuff. The Fed’s goal is to keep inflation at 2%.

While the Fed made a popular decision by signalling two rather than four rate increases in 2016, that gesture is 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. 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. Investors be warned. The Fed has taken a wager the world can ill afford to go wrong.

To be sure, the next rate move by the Fed could just as easily be a rate cut, according to those who worry about a US recession. Inflation may well stay below 2%. Even if inflation does break beyond 2%, the Fed could conduct sensible rate increases and manage investor expectations in such a deft way that it avoids any ructions. No one expects inflation to spiral out of control. But we are talking about inflation, the main credibility test for a central bank these days. If the US inflation rate pops beyond 2%, the Fed would have little choice but to raise rates at a faster pace than planned. The longer the Fed dawdles on fighting any inflation, the higher rates could go and the bigger the jolt to the US and world economies.

That curve

In 1958, New Zealand economist Bill Phillips analysed the link between the jobless rate and wages growth in the UK from 1861 to 1957. Essentially, the statistical analysis sought to establish the relationship between unemployment and inflation because growth in wages, the biggest part of production costs, was seen as the trigger for a general rise in prices.

The result was the Phillips curve which, as the first half of a U with inflation measured on the vertical axis and the jobless rate tracked on the horizontal axis, shows an inverse short-term relationship between the two. The Phillips curve and the analysis it spurred suggest that at low levels of unemployment, an economy risks a sudden outbreak of inflation.

The Phillips curve always had its limitations. Arguments, for instance, have raged over its steepness and it was discredited by the stagflation of the 1970s. Milton Friedman famously showed the Phillips curve (and, thus, the Keynesian) trade-off between inflation and unemployment was an illusion because people and businesses adjusted their behaviours to match their expectations for inflation. Friedman’s point meant unemployment and steady inflation could coexist with inflation at any level; that the Phillips curve was a vertical line. The monetarist argued that unemployment would stabilise at some indeterminate, but unknowable, point consistent with price stability, a point he called the natural rate of unemployment (a level that’s often called the non-accelerating inflation rate of unemployment).[4]

Friedman’s monetary theories and the school of rational expectations it spurred have, in turn, been discredited by events, especially by the global financial crisis. The corresponding rise of Neo-Keynesianism has resurrected some belief in the Phillips curve. Fed Chair Janet Yellen is one such supporter. In 2007, she described the curve as a “core component of every realistic macroeconomic model”.[5] Yellen’s challenge then is to judge how far the US jobless rate can drop without sparking inflation – or, in Friedman speak, to estimate what is today’s natural rate of unemployment.

The immediacy of Yellen’s task is that just about every indicator of the health of the US labour market is screaming “full employment”. The US economy has added 13.4 million jobs since the end of 2009, including 2.4 million jobs over the six months to March. Job vacancies were at a 16-year high in March. The bellwether (U-3) jobless rate has halved from a peak of 10% in October 2009 to 5% in March. A wider (U-6) measure of the labour market, which seeks to track hidden unemployment, has plunged from 17.1% in 2009-10 to 9.8% in March. On top of that, the participation rate is rising, after falling from 66.1% in 2008 to a post-crisis low of 62.4% in September last year – an estimated loss to the workforce of eight million despairing people. The ratio of employed or those looking for work divided by the working-age population climbed to a two-year-high of 63% in March, an addition of 1.5 million jobseekers to the US workforce (which now numbers 159.3 million people).[6] When the participation rate rises, an economy must create as many jobs as the number of new entrants to keep the jobless rate steady. The rise in the jobless rate from a seven-year low of 4.9% in February to 5% in March was because the 210,000 jobs created in March failed to offset the estimated 365,000 newcomers into the labour force that month.

More people re-entering the workforce, in theory, should help suppress wage gains. But at the same time, more people with more money stoke demand-drive price gains. So far, wage gains are modest – average weekly earnings rose 2.3% in the 12 months to February.[7] The biggest aspect to Yellen’s gamble is that this gradual growth in wages holds. It should worry her that, according to the Atlanta Fed, wages of private workers employed for more than 12 months swelled 3.2% in the 12 months to February.[8]

Another of Yellen’s gambles is the price of oil (and commodities more broadly). The 50% jump in Texas Intermediate crude from its 12-year low of US$26.21 per barrel on February 11 shows oil looms as a source of inflationary, rather than deflationary, pressure.

Her third wager is the US dollar, which had soared 22% on a trade-weighted basis in the two years to January. This ascent, driven by a view the US rates were about to climb, helps tame inflation by lowering import prices. If the US dollar declines, the reverse applies. The US dollar has drifted down 2.9% over the past two months on a trade-weighted basis and could go lower if a view prevails that US interest rates will hover for a while.[9]

Yellen is basically saying the poor outlook for China and, consequently, commodity prices offset these three risks to inflation. Essentially, her view on US interest rates is grounded in a poor global outlook rather than a healthy US one.

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 prices stability.[10] 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.[11] 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? She, of course, could cite examples whereby policymakers crunched the economy by prematurely tightening monetary policy, most famously in 1937 when fiscal policy was squeezed too. Yellen sees that there is more spare capacity in the labour market than statistics indicate – that the Phillips curve is flatter these days because many people are still to rejoin the workforce and because inflation expectations are low, or “well anchored”, as she puts it. Yellen dismisses higher inflation readings as aberrations – caused by “transitory factors” in “categories that tend to be quite volatile” namely clothing, medicine and jewellery. She says this even though prices are rising for items not considered volatile such as health insurance and pay TV. She scorns the threat of inflation even though she admits real interest rates are 1.25% below their “neutral 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.


[1] The 17 projections for the US cash rate are displayed in a graph known as the “dot plot”.

[2] Federal Reserve. “Federal Reserve issues FOMC statement.” 16 March 2016.

The Fed board voted 9 to 1 on this decision, with one vote for a rate increase. Note that only four of the 11 regional Fed presidents outside of New York vote on rate decisions in any year, even though all take part in the discussion and forecasts. The right to vote rotates.

[3] The Federal Reserve of Cleveland’s core measures rose at 2.8% (median CPI) and 2.6% (16% trimmed-mean CPI) annualised rates in February. Federal Reserve Bank of Cleveland. Release. Median CPI. 16 March 2016.

The Federal Reserve of Atlanta’s stick-price CPI reached an annualised rate of 2.67% in February, following on from a 2.97% reading in January. Federal Reserve Bank of Atlanta. Sticky-price CPI.

[4] For a brief history of the Phillips curve and beyond, read chapter 3 “Dynamic scholastic general equilibrium” in “Zombie economics” by John Quiggin. Princeton University Press. 2012.

[5] Janet Yellen speech. “Implications of behavioural economics for monetary policy.” Federal Reserve Bank of Boston conference. 28 September 2007.

[6] United States Department of Labor. Bureau of Labor Statistics. “Top picks” statistical resources of latest statistics on the labour force.

[7] US Department of Labor. Bureau of Labor Statistics. Employment situation summary. 1 April 2016.

[8] Federal Reserve Bank of Atlanta. Wage growth tracker.

[9] Federal Reserve. Foreign exchange rates – H.10. Nominal broad dollar index – monthly index. 1 April 2016.

[10] For more information on the Fed’s mistakes during the 1960s, see “Monetary policy mistakes and the evolution of inflation expectations” by Athanasios Orphanides of the Central Bank of Cyprus and John C. Williams of the Federal Reserve Bank of San Francisco. May 2011.

[11] Allan H. Meltzer. “Origins of the great inflation.” Originally appeared in the Federal Reserve Bank of St. Louis Review, March/April 2005. Now can be found at on the Federal Reserve website under a section on history “The great inflation”.