Penn Mutual Asset Management CIO Mark Heppenstall contributed an article to The Hill where he discusses persistent “lowflation” since the financial crisis and how it has enabled the Federal Reserve’s patience in raising rates. As economic expansion extends into record territory, Mark explains why the balance is likely to shift between secular and cyclical linkages to inflation. The post originally appeared on The Hill on 10/22/2018 and can be found below.
Persistent low inflation in the United States during the past 25 years has been the gift that keeps on giving for Federal Reserve policymakers. It gives the central bank greater flexibility around its dual mandate goal of maximum employment consistent with price stability. With inflation just now reaching the 2 percent target, monetary policy after the financial crisis has focused squarely on the goal of full employment.
Critics labeled the dual mandate as “mission impossible” following the financial crisis. They argued the unprecedented measures the Fed took with monetary accommodation to prop up the economy and boost employment could only be realized at the expense of price stability. Easy money by the Fed would devalue our currency and boost inflation, or as Speaker Paul Ryan once suggested, “put the fiat” in fiat money.
Ten years and three rounds of quantitative easing later, the inflation bogeyman has yet to arrive in the United States. Instead, the Fed is gradually unwinding stimulus, with inflation, and more importantly inflation expectations, entrenched near the 2 percent target. Even though Chairman Jerome Powell sees “no clear sign of an acceleration” in inflation, the removal of “accommodative” from the last Federal Open Market Committee statement is a sign that the Fed is shifting its focus from economic growth and employment to price stability.
Disinflationary secular forces, including globalization, technology, the sharing economy, and an aging demographic, have so far outweighed typical late stage cyclical pressures for higher inflation in the United States and other developed countries, as mentioned in a blog post by the Federal Reserve Bank of Saint Louis earlier this year. The absence of inflation in the midst of record tight labor market conditions has perplexed Fed officials and called into question the usefulness of economic forecasting tools such as the Phillips curve, which posits that inflation and unemployment rates are inversely related. At a recent speech, Powell best summarized the challenges by remarking that the Federal Open Market Committee “has been navigating between the shoals of overheating and premature tightening with only a hazy view.”
As the economic expansion and bull market in stocks extend into record territory, however, the balance is likely to shift between secular and cyclical linkages to inflation. Wage growth is likely to surprise to the upside with current labor market conditions tightening deeper into record territory. The Federal Open Market Committee keeps lowering its estimated range of the sustainable unemployment rate, while the actual unemployment rate in the United States drops even faster. The recent decision by Amazon to raise its minimum wage to $15 for all of its American workers was likely driven more by the need to attract labor for the upcoming holiday shopping season than the benevolence of Jeff Bezos or political pressure building from both sides of the aisle.
Furthermore, the “America First” policies focused on growth under the Trump administration also raise the risk of inflation moving higher when cyclical inflation pressures intensify. The trend of globalization is reversing its course. Escalating trade tensions with China, geopolitical conflicts including the situation with Saudi Arabia, and tighter immigration policies are all examples. The passage of tax reform last year is boosting growth, but increases the risk that the economy will overheat.
Despite numerous critics at every turn, the Fed has successfully navigated the path to normalize monetary policy since the financial crisis. It has gradually pared extraordinary measures of accommodation without derailing the long period of economic expansion. The “misery index” of the economic health for an average citizen has been trending lower since 2011 and is currently near the lowest level since the 1950s.
The dilemma for the central bank now is whether the extraordinary times are in fact “too good to be true” as Powell mentioned during a meeting of the National Association for Business Economics this month. Risks are growing that the economy and inflation may start to run too hot after years of “Goldilocks” growth and inflation below the 2 percent target. The transition will move inflation to the front of the dual mandate focus and raises the risk that the Fed will make a policy mistake.