Low Inflation Gives Fed Pause on Raising Rates Again This Year
By Nick Timiraos
Stubbornly low inflation readings are giving Federal Reserve officials second thoughts about whether they will be in a position to raise short-term interest rates again this year.
Several Fed officials have indicated in recent interviews and public comments they are poised to announce at their meeting Sept. 19-20 that in October they will start slowly shrinking the central bank's $4.5 trillion holdings of bonds and other assets and to leave rates unchanged.
The bigger question about the meeting is how many officials will again project one more interest-rate increase this year, as a large majority did in June, and what Fed Chairwoman Janet Yellen will say on the matter during her news conference after the meeting in light of an inflation soft patch that has lasted longer than officials expected.
With the unemployment rate falling to the low range of officials' projections, most expect inflation should eventually rise to the Fed's 2% target. But because inflation has remained weak for several months and short-term interest rates have moved closer this year to their long-run level, some officials have said they want to see more evidence of a pickup in prices before moving again.
"We have the ability to be patient," said Dallas Fed President Rob Kaplan in an interview on Aug. 25. "Inflationary forces are likely building ... but my point is they're building in a more muted way than we've seen historically."
In June, Ms. Yellen said inflation appeared to be soft due to transitory factors, including one-off declines for a handful of items such as wireless phone plans and prescription drugs. In July, she said that was still her expectation, but she qualified her statement with a nod to the inherent uncertainty.
"It's premature to conclude that the underlying inflation trend is falling well short of 2%," Ms. Yellen told lawmakers. She added, "Policy is not something that's set in stone, and if our evaluation changes with respect to inflation, that will make a difference."
Officials are puzzled because inflation has remained weak despite solid, if moderate, economic growth and very low unemployment, which was 4.4% in August.
One possible explanation is just that inflation readings can vary a lot over short periods. Another is that labor market slack is greater than the jobless rate indicates.
Several officials have said they believe tight labor markets are now forcing employers to compete for workers, which should lead to rising wages and prices and which justifies another rate increase this year.
"I'm now more concerned that we're beyond what's going to be sustainable unemployment," said Boston Fed President Eric Rosengren in an interview last month.
Still, if inflation doesn't soon show signs of an upturn and the unemployment rate doesn't fall much further from its recent low of 4.3%, officials could decide to forego another rate move by year's end.
Already, the probability of another rate rise as implied by futures markets have fallen to around one in three, according to CME Group, reflecting markets' grasp of the central bank's inflation dilemma. Top Fed officials have done nothing recently to alter those expectations.
In each of the last two years, Fed officials have said they expected to raise interest rates around four times, only to see potential global growth shocks prompt them to change course. They raised rates once at the end of 2015 and once at the end of 2016.
This year had been different. The Fed raised rates twice by June, to a range between 1% and 1.25%, and officials unveiled their balance-sheet strategy. But inflation this spring started to fall away from their 2% target, which was a surprise given steady declines in unemployment.
Excluding the volatile food and energy categories, consumer prices rose 1.4% from a year earlier in July, according to the Fed's preferred inflation gauge, down from 1.9% in January.
In a speech Tuesday, Fed Governor Lael Brainard laid out a detailed argument against further rate increases if inflation pressures remain subdued. "Frequent or extended periods of low inflation run the risk of pulling down private-sector inflation expectations," she said.
Ms. Brainard has underlined such concerns in the past and is considered one of the more dovish members of the Fed's rate-setting committee, meaning she is more cautious than others about raising rates. But she nevertheless voted to lift them three times in as many quarters over the past year. Her speech revealed she was setting a higher bar to continue with rate increases.
Other officials who are voting members of the Fed's rate-setting committee and who have voted to lift borrowing costs this year -- including Mr. Kaplan, Chicago Fed President Charles Evans, and Philadelphia Fed President Patrick Harker -- have said they, too, want to see more proof that inflation is returning toward the target before raising rates.
Ms. Brainard said it was "troubling" that the Fed for five straight years has seen inflation fall short of 2% despite sharp declines in measures of slack across the economy. Returning inflation back to the target, she added, is especially important given that once interest rates return to a more normal level, they are likely to be much lower than in the past, giving the Fed less room to cut them if the economy weakens.
Ms. Yellen outlined her model for evaluating inflation in a seminal speech almost exactly two years ago in Amherst, Mass., that included dozens of footnotes replete with detailed equations. She walked through reasons why the Fed could look past the inflation shortfall relative to the 2% target, including a decline in energy and import prices, a stronger dollar and some labor-market slack. Those factors haven't been able to explain the inflation weakness this year, raising more questions about what is happening in the economy and clouding the near-term rate path.
Meantime, markets have barely reacted to the Fed's plans for reducing its bond holdings, or balance sheet, and Congress has moved closer to resolving for now a standoff over the federal borrowing limit, giving officials a green light to initiate the process at the start of October.
The Fed stopped adding to its holdings of Treasury and mortgage bonds in 2014 but has reinvested the principal from maturing assets to maintain the bond holdings. The wind-down plan calls for slowing those reinvestments by allowing up to $6 billion in Treasuries and $4 billion in mortgage bonds to mature every month. Every quarter, the Fed will allow monthly net maturities to increase until they reach a maximum of $30 billion for Treasuries and $20 billion for mortgages.
The balance sheet plan removes one source of uncertainty for markets, but the policy path over the coming year will remain clouded until the Trump administration announces its plans for the central bank's leadership. Vice Chair Stanley Fischer said Wednesday he would resign, effective Oct. 13, for personal reasons. His term was set to run until next June.
Ms. Yellen's term as chairwoman, meanwhile, ends in early February, and the White House has yet to name its picks for two of three other vacant board seats. All seats are subject to Senate confirmation. The Senate Banking Committee on Thursday advanced the president's nominee to serve as the Fed's vice chair for bank regulation, private-equity executive Randal Quarles, on a 17-to-6 vote.
Write to Nick Timiraos at [email protected]