Low Inflation Continues to Perplex Fed

In our view, the Federal Reserve is walking a fine line as it attempts to normalize rates

Jim Sinegal 02.11.2017
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The Federal Reserve Open Market Committee decided to maintain the target federal funds rate at 1.0%-1.25%, as declines in the unemployment rate, growth in household spending, and increases in corporate investment have been offset somewhat by softness in inflation.

We believe that low inflation readings support the thesis that a combination of demographic, technological, and financial factors have lowered the equilibrium rate to some extent. Thus, the desired combination of full employment and modest inflation may be occurring in a relatively low-rate environment, making aggressive tightening of monetary policy unnecessary.

We think the Federal Reserve’s cautious approach is the correct one given the state of the economy. In our view, the Federal Reserve is walking a fine line as it attempts to normalize rates. Returning to a “normal” interest rate environment would give the central bank more ability to fight a recession, and the combination of low unemployment rates and solid economic growth arguably shows the economy is ready for higher rates. However, tightening too quickly—before inflation data proves the need for higher rates—could cut short a long and fragile recovery. We continue to expect a slow and steady normalization—in line with the Fed’s commentary.

Rumors abound that Donald Trump will soon appoint Jerome Powell as Janet Yellen’s replacement. In our view, such a move is unlikely to alter the course of monetary policy. Powell seems inclined to continue the data-driven approach favored by Ms. Yellen, rather than setting policy based on political preconceptions. We think this is a wise course, given the somewhat puzzling interaction between employment and inflation in recent months. Mr. Powell’s relative lack of formal economic training may also support a more pragmatic approach to policy, rather than one dictated by theoretical dogma.

 

 

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Jim Sinegal  Jim Sinegal is the associate director of the financial team at Morningstar.

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