Not only is core-PCE inflation on a year-over-year basis trending away from the Fed's target:
but the deceleration in recent months is truly shocking:
It is hard to see how the Fed can be confident that inflation with trend back to target when looking at these numbers. They need some acceleration in wage growth to justify their intentions to begin normalizing policy, and even with such acceleration, I think their case is fairly weak in the context of the current inflation environment. If they make a case, they will base it on these three pillars:
1.) With unemployment nearing 5%, they have reached their employment mandate.
2.) Monetary policy is exceptionally accommodative even if they raise interest rates.
3.) Failure to raise rates invites asset bubbles.
On point three, refer to New York Federal Reserve President William Dudley:
Quickly, let me give two examples that illustrate how variable this linkage can be. First, during the 2004-07 period, the FOMC tightened monetary policy nearly continuously, raising the federal funds rate from 1 percent to 5.25 percent in 17 steps. However, during this period, 10-year Treasury note yields did not rise much, credit spreads generally narrowed and U.S. equity price indices moved higher. Moreover, the availability of mortgage credit eased, rather than tightened. As a result, financial market conditions did not tighten.
As a result, financial conditions remained quite loose, despite the large increase in the federal funds rate. With the benefit of hindsight, it seems that either monetary policy should have been tightened more aggressively or macroprudential measures should have been implemented in order to tighten credit conditions in the overheated housing sector.
It may be that the Fed looks at the tech and housing bubble episodes and concludes that zero interest rates are not desirable even if inflation is below trend. Yes, I know, macroprudential before interest rates when addressing asset bubbles. But at a point when the economy is at the Fed's idea of full-employment, and given the events of recent decades? Easy to see the Fed seeing danger in putting all of their eggs in the macroprudential basket.
Bottom Line: Below trend inflation as the economy nears full-employment is a very uncomfortable position for the Federal Reserve. It will be interesting to see how Federal Reserve Chair Janet Yellen navigates these waters at the upcoming Congressional testimony.
