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America s economy - On the one hand

2016-03-16 04:24:55

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.