Is Inflation Back In The Game?

by: John M. Mason

The core inflation rate finally got back up to 2.0 percent year over year, and the Federal Reserve appears to believe that it will stay there or even rise a little more.

The behavior of inflation throughout the entire current period of economic recovery has not been fully understood and so questions are being raised about how it will behave going forward.

Fed Chairman Powell has stated that this news must be seriously reviewed so that inflation does not get out of hand.

The Fed must be closely watched because a pickup in inflation could change the whole ball game.

During almost all of the current economic recovery from the Great Recession, one of the major questions has been… where is inflation?

At times, there was even concern, especially in Europe, about the possibility that deflation might become a problem.

Even through three rounds of quantitative easing in the United States and an unemployment rate that dropped below what many considered to be the full employment level, the rate of inflation seemed to be on the tepid side.

Last Friday, that changed for a lot of people.

On that day, the Commerce Department released the data on the two consumer price indices that the Federal Reserve watches most closely. The Fed’s target goal for inflation is 2.0 percent.

The broad measure of consumer prices showed a 2.3 percent year-over-year rate of growth for May. Although this particular measure has jumped around in the 2.0 percent range several times, there have not been firm signs that it will stay around or above this level.

The more crucial measure of inflation is the core consumer price index, the measure that excludes food and energy prices because of their volatility, and the May figure came in 2.0 percent over the level of the index in May 2017.

This is the first time in recent years when this core measure came in at the 2.0 percent level.

Justin Lahart writes in the Wall Street Journal: “So, after years of frustration over doggedly low inflation, mission accomplished for the Fed.”

Well, Mr. Lahart may be overstating things. After all, this is just a one month accomplishment.

After all, since May 2011, this core measure of consumer price inflation has averaged only 1.3 percent, and even in this measure, which is supposed to be more stable than the total consumer price index, there has been quite a bit of variation over the past seven years.

But, Mr. Lahart insists that there are several reasons to believe that the rate of inflation will stay around two percent… or, even rise to levels modestly above the 2.0 percent.

Even officials at the Federal Reserve believe, on average, that Core PCE inflation will be 2.0 percent for 2018 and will move up to a 2.1 percent level for both 2019 and 2020.

Thus, it seems as if inflation has picked up and will, for the next couple of years, test the Federal Reserve policy makers to keep the core inflation rate under control.

Remember, the Federal Reserve, as far as we still know, is data driven.

Fed Chair Jerome Powell has recently reiterated this fact. At the news conference after the last rate increase, Mr. Powell insisted that the Fed would “cool things off ‘if inflation were to persistently run above’ 2 percent.”

What does this mean? Well, officials at the Fed have already signaled that there would be two more increases in the policy rate of interest this year and then there would be three more increases in 2019.

Also, the Fed is in the midst of reducing the size of its securities portfolio.

The financial markets seem to have these expectations built into the pricing of financial assets.

But, Mr. Powell seems to be signaling to market participants that these expectations may be disappointed if the data support a different policy stance. And, if the data support a different policy stance, market participants need to understand that the Federal Reserve will not hesitate to tighten up where necessary.

And, what does that mean?

More interest rate increases coming at shorter time intervals?

A greater effort to reduce the size of the Fed’s securities portfolio… and the Fed’s balance sheet… at a faster pace?

In a real sense, this is the "new" Fed that has evolved from the early days of former Fed Chair Ben Bernanke. Mr. Bernanke was always one who believed that the Fed needed to signal the market what the Fed was aiming for. He believed that in doing this, and then backing up the talk with action, the financial markets and the banking system would adjust more smoothly to what the Federal Reserve was trying to achieve.

During Mr. Bernanke’s tenure at the Fed, this process of “forward guidance” became more and more common as the Fed achieved more and more credibility by actually following up the “forward guidance” with its actual management of its balance sheet.

The latest effort to use “forward guidance” as a consistent component of the Fed’s monetary efforts took place as the third round of quantitative easing was brought to an end. The Federal Reserve signaled that it would begin to increase its policy rate of interest, although it would not accomplish this by outright sales or purchases of open-market securities.

Instead, the Fed used tools such as reverse repurchase agreements, and its term deposit facility, temporary means, to manage its balance sheet and achieve its interest rates goals.

Last October, the Fed moved into the second phase of this effort as it moved from the use of these short-term tools to manage the rate increases, to systematically reducing the size of its securities portfolio.

The Fed has done a very credible job through this time period to tell market participants what it was going to do and then actually doing what it told the market participants what it was going to do.

Now, Mr. Powell is signaling that this stage of the Fed’s monetary policy may be over.

We have been watching for this signal for a long time, since Mr. Bernanke appeared at an August meeting at Jackson Hole, Wyoming, and introduced the movement away from quantitative easing.

The Fed’s actions since that earlier date have always been aimed at erring on the side of monetary ease so as to reduce the possibility of further disruptions to the commercial banking sector. The banking sector benefitted from this, the economy benefitted from this, and especially the stock market benefited from this.

If inflation is back in the game, then the whole ballgame could change with the Federal Reserve at the forefront. The stance to look for: policy movements to resist the rise in inflation, which would replace a monetary policy effort to underwrite an increasing stock market.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.