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Inflation is rising, but households have yet to notice
Mar 12th 2016 | WASHINGTON, DC
IT IS a tough time to be a central banker. On March 8th the IMF called for more
stimulus globally to see off a lack of demand in the world economy. On the same
day economists at the Peterson Institute, a think-tank, issued a report that
was labelled a reality check , arguing that fears for the world economy were
overblown. (One of the report s authors, Olivier Blanchard, was until last year
the IMF s chief economist.) The disagreement reflects conflicting signals that
the Federal Reserve must untangle at its next meeting, which begins on March
15th.
When the Fed raised interest rates by a quarter-point in December, after seven
years without a change, inflation was still in the doldrums. According to the
central bank s preferred measure, prices were rising by just 0.5% a year. The
Fed raised rates anyway: Janet Yellen, its chair, argued that the fizzing
labour market meant inflation must be on the way. Waiting for it to arrive
before raising rates might force the Fed to yank them up abruptly later,
potentially triggering a recession. Crucially, households inflation
expectations had not fallen much, so the Fed could argue that its 2% inflation
target remained credible even as it tightened policy.
Since lift-off in December, worries about the global economy have sent
stockmarkets sliding. The S&P 500 has fallen by about 5% since then; in the
gloomiest moment in February, it was 12% down. But America s labour market has
not been gyrating in the same way. In February the economy created 242,000
jobs, many more than the roughly 100,000 thought to be needed to stop
unemployment rising.
What is more, Ms Yellen s prediction is beginning to come true. Core inflation,
which excludes food and energy prices, was 1.7% in January, its highest level
since 2013. The headline measure has risen too, to 1.3% still well below
target, but a marked increase nonetheless. Rate-setters are likely to raise
their forecasts for core inflation at their meeting this month, according to
Zach Pandl of Goldman Sachs.
But not every measure is following Ms Yellen s script. According to the
University of Michigan s survey of consumers, Americans inflation expectations
have dipped to 2.5%. Although that is above the Fed s target, consumers usually
predict inflation that is higher still. Their expectations today are 0.5
percentage points below their long-term average, and as low as they have been
since 2010.
Consumers may have only now adapted to a world of cheap fuel and a strong
dollar. If so, rising inflation should gradually turn their forecasts around.
But measures of inflation expectations in financial markets usually thought of
as more forward-looking than consumers have been depressed for some time. The
difference between yields on inflation-protected government bonds and the
normal kind points to inflation of just 1.4% over the next five years. (This
measure also rallied in the second half of February, having previously dipped
below 1%, its lowest level since the crisis.)
Ms Yellen is sceptical of these barometers. The market for inflation-protected
bonds is less liquid than before the financial crisis. That means investors
might demand a higher return to hold these bonds rather than regular ones,
compressing the spread between the two. The inflation-risk premium , which
investors demand to insure themselves against very high levels of inflation,
may also have come down (this can happen without the mean forecast for
inflation changing). It is unlikely, though, that such factors fully account
for investors apparent nonchalance about inflation. The swaps market, which
suffers less from such problems, points to medium-term inflation of around
1.7%. Markets, it seems, think the likely path of monetary policy is too tight.
Yet Americans continue to spend strongly, as Mr Blanchard and his colleagues
point out. Incomes and spending both rose by a robust 0.5% in January. Retail
sales are strong.
In December most rate-setters forecast another interest-rate rise at the coming
meeting. That now looks very unlikely, thanks to the gloomy global picture. But
the Fed may be in the curious position of marking up its inflation forecasts
even as it postpones rate rises. The recent financial volatility, which could
be a sign of problems to come, justifies the change of heart. But with the
domestic economy purring, it would not take much of a climb in the oil price,
or a fall in the dollar, to push inflation higher still. Markets expect only
one interest-rate rise this year, and only three more rises by the end of 2018.
They are probably underestimating.