History and Rational behind the 2% Inflation Target
The Federal Reserve inflation target of 2% is widely known in the investment community. This inflation target was first adopted during the January 2012 Federal Open Market Committee (FOMC) meeting with the following statement:
"The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate."
Besides referring to its price stability mandate, the FOMC also provided a soft unemployment target of 5.2% to 6.0% as a measure of full employment over the long term. This is considered as a soft unemployment target as the Fed qualified this target not directly measurable and subjected to revision. Nevertheless, this measure of unemployment gives us a ballpark figure about the maximum employment figure for the US. The relevant quote that established this soft unemployment target is quoted below:
"For example, in the most recent projections, FOMC participants' estimates of the longer-run normal rate of unemployment had a central tendency of 5.2 percent to 6.0 percent, roughly unchanged from last January but substantially higher than the corresponding interval several years earlier."
In other words, to summarize the rationale behind the Fed 2% inflation target is to encourage consumption and provide an outlet for businesses to reduce wages in tough times. In an environment where consumers know that they are not going to get lower prices tomorrow, they are unlikely to delay expenditure and causing the economy to contract in the process. In addition, in a difficult economic environment in the aftermath of the Great Recession of 2009 where the economy shrank by 9%, this 2% inflation target allows businesses to reduce their real wages without having to fire their employees to lower cost. This would help to avoid employee's resistance of lower nominal wages and keep unemployment low. This will help the economy to pick up faster in the future.
Assessment of the Current Situation
Now we are at the future. At the year end of 2014, it is time that we take a check of these assumption. First let us look at the current unemployment condition.
The unemployment figure is reflected on the dotted line and the right hand side of the y-axis. As we can see the unemployment rate has been trending downwards to the current 5.8% rate. This is within the maximum employment range of 5.2% to 6.0% indicated by the Fed earlier. In addition, we can see that GDP growth has been strong and has reached 3.9% for the third quarter of 2014.
Next we look at the personal consumption expenditure (PCE) which the Fed used to measure inflation.
We can see that current PCE inflation is at 1.55%. When the Fed announced it 2% target, the PCE inflation was at 2.01% and it would subsequently peak on March 2014 at 2.04%. For the past 2 years, PCE inflation has not even reached 1.75% despite the economic improvement. This can be attributed to the loose monetary condition by the Fed and other central banks and the low energy prices which we will explore later.
However the point of the segment is that we can see that the Fed has more or less been successful in reaching its unemployment target. Given that the economic recovery is going to continue, it would be reasonable to assume that employment will pick up further from now on.
Reasons for low inflation to persist
Now that we have set the history and context of the current situation, we can now move on to the assessment of the latest December 2014 FOMC Statement. The Statement made the correct assessment that the low inflation can be attributed to low energy prices but it made the assumption that it will be transitory as seen in the quote below:
"The Committee expects inflation to rise gradually toward 2 percent as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate. The Committee continues to monitor inflation developments closely."
This is where I would challenge the assumption that low energy prices are transitory. For a better understanding, you can read this excellent article by Kyle Spencer titled 'Why Cheap Oil May Be Here To Stay' where he gave a detailed explanation of why the oil glut may be here to stay despite low of prices and how oil consumption may wane due to demographics and technology. For a sense of the time frame, the 1981 oil price dropped for 5 years below the market stopped its sharp decline.
So how can we be sure that this decline in oil prices will reverse next year in 2015? It is entirely possible that this 'transitory' decline in oil prices could last for 5 years too.
The chart above shows the severity of the decline today. So the key question of whether this price decline is a temporary displacement or a new paradigm is a question for each individual investors to decide for themselves. However make no mistake, this is an important question where fortunes will be made or lost.
In addition, inflation will be constrained by the flood of liquidity by foreign central banks. This would include the 3 Trillion euro targeted asset expansion by the European Central Bank (ECB) and the annual 80 Trillion yen balance sheet expansion by the Bank of Japan (BoJ). The ECB set a deadline of June 2016 for its expansion although it may be extended due to the state of the economy at that time. The BoJ gave an open-ended commitment to its economic expansion program. In other words, we can expect this foreign liquidity glut to last for at least the next 18 months.
Even though the Fed has ended QE3 and is on the march to raise interest rates, it is not about to tighten monetary policy drastically anytime soon. It may be the aftereffects of the Great Depression of 1929 where it is widely agreed that it is the premature tightening of the Fed policy that led to the Great Depression. In fact, the December 2014 FOMC states clearly that:
"The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee's holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions."
Consider this statement too:
"Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy."
This monetary divergence would mean that the United States dollar (NYSEARCA:USD) will strengthen over time and the euro and yen will decline. This will have multiple influence on inflation. Firstly it will act to put a lid on oil prices in addition to those mentioned in that article. Secondly it will 'import' low inflation to the United States by means of carry trade. The carry trade will allow corporate borrowers to borrow cheaply in euros and yen and take advantage of the strengthening USD to pay with lesser USD as the funding currency depreciates in value. In fact, as credit conditions get tighter, the carry trade will gain prominence and result in lower inflation. Hence we can expect low inflation to persist for the next 18 to 60 months
Case for 1% Fed Inflation Target
The Fed is going to have a hard time meeting its 2% inflation target in the face of these forces pushing down inflation. Now that the economy is recovering steadily, it would be reckless for the Fed to loosen monetary policy. While the Great Depression of 1929 cautions against the premature monetary tightening, the recent Great Recession of 2009 can be attributed to loose monetary policy together with lax banking supervision. Hence for the sake of financial stability, the Fed would have to maintain its pace of monetary tightening.
Low energy prices is not always immediately reflected in prices of goods and services as businesses would want to see if this is transitory or not. However as low energy price persists, this will be passed on to consumers due to competitive pressures.
The key to note is that low prices is not a natural phenomenon where lack of consumer confidence leads to lower consumption and a vicious cycle of lower wages which would repeat itself. Average wages are held steady at $10.34 per hour and we can see that despite the decline in energy prices, retail sales still increased at a higher pace of 5.1% year on year.
This would mean that the Fed's objective of price stability can be met with a 1% inflation target rather than a 2% inflation. Despite a 1.55% inflation reading, we see that wages are not falling and consumption is actually rising over time. If low oil prices are indeed here to stay and as the effects of the foreign liquidity floods takes hold, we can see a declining PCE inflation towards 1%.
In a normal economic expansion, we will see that as the economy pushes against its production boundary, the increase in demand will necessitate higher prices. Today with latest quarter GDP growth of 3.9%, we are seeing capacity utilization rate of 80.1%. This would imply that technology is improving productivity and as the economy improves, there will be more goods and services produced at the same or lower prices.
Of course, this 1% target is an arbitrary figure. The optimal figure can be 0.9% or 1.1% and would be determined if the Fed were to conduct research on it. However with the current assessment, a 1% inflation target is more realistic than a 2% inflation target and it would have the same intended results.
In fact, the United States could possibly now have the best of both worlds of strong economic growth and very low inflation due to the economic divergence and energy supply glut. This would result in a strong growth in real income and form the basis for a strong economic recovery. This will also cause us to rethink the current economic paradigm (i.e. Abenomics) that high inflation is preferable to low inflation as it would be helpful in economic growth.
Just as we saw high inflation and stagnant growth in the 1970s and 1980s which is subsequently known as stagflation, we could see the reverse of stagflation with high economic growth and low inflation. After a Google and Investopedia search, it would appear that there is no single word to describe this phenomenon that is about to occur. Hence I would coin this phenomenon as growflation, a portmanteau of growth and inflation. I did a search on Investopedia and did not find a match or meaning for it. A Google search revealed a blog that used this word to describe India's growth but without explaining what the author meant by it.
Hence I am quite sure that you are reading about growflation here first at SeekingAlpha. If the phenomenon of high growth and low inflation were to occur in the United States, I am quite sure that growflation will be formally adopted by Investopedia and other mainstream dictionary as a new term to describe high inflation and low growth. Growflation is likely to be cemented if the Fed were to formally adopt the 1% inflation target.
The Fed would be monitoring the current situation closely as it indicated in its latest FOMC Statement. If conditions were to unfold as I have predicted, we can expect the Fed to adjust its inflation target from 2% to 1% in 2015. This would have a higher probability after it announced its first rate hike in 2015 as it cannot afford to signal confusing message by increasing and decreasing rates in the same year.
Once the Fed has set its inflation target at 1%, it would be in a better position to raise interest rates and tighten monetary policy further as the economy improves steadily. This will provide a new source of strength for the USD going forward in 2015. Growflation would also be bullish for the equity market even as the USD strengthen as it provides a steady base for sustained economic growth in the United States.
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The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.