The Fed, Inflation Expectations and the Dollar
Raymond James
Scott J. Brown
October 18, 2010
Will they or won’t they? The September 21 policy meeting minutes and comments by senior Fed officials suggest that the Federal Open Market Committee is leaning toward further monetary accommodation (specifically, additional purchases of long-term Treasury securities). However, it’s not entirely settled. There are excellent arguments for doing more, but also a number of reasons for the Fed to be cautious. Most likely, the FOMC will pull the trigger on November 3. In the meantime, the uncertainty has added to the volatility in the financial markets.
Core inflation (the Consumer Price Index ex-food & energy) was unchanged in August and September – a 0.6% annual rate in the first nine months of the year. That’s low. One of the main reasons is that homeowners equivalent rent has been trending flat (ex-food, energy, shelter, and used cars, the CPI rose at a 1.0% annual rate in the first nine months of 2010).
Economists are interested in real (that is, inflation-adjusted) activity. We’re all used to real Gross Domestic Product, but one can also adjust interest rates for inflation. Low short-term interest rates act to stimulate the economy in a variety of ways (for example, by raising the relative cost of holding cash). However, it’s real interest rates that matter.
The recent disinflation (the fall in the inflation rate) has led to some reduction in expected inflation. On Friday, the Cleveland Fed said that its model currently estimates 10-year inflation expectations at 1.53% (in comparison, the average 10-year inflation expectation was 2.4% over the previous decade).
A drop in inflation expectations, all else equal, raises real short-term interest rates, dampening economic activity. Conversely, a rise in inflation expectations lowers real short-term interest rates, stimulating economic activity. The Fed has lowered the overnight lending rate to effectively 0% (the target is 0% to 0.25% and the average over the last two quarters has been 0.19%). It can’t lower this rate below 0%. So, to reduce real short-term interest rates, the Fed has to lift inflation expectations. It could do that by announcing an explicit inflation target. When he was an academic, Bernanke was in favor of a flexible inflation-targeting strategy for the Fed (note that most central banks have an inflation target). However, there’s been no noticeable push to adopt such a framework under his tenure as Fed chairman. Another possibility would be for the Fed to commit to keeping short-term interest rates low for a long time (something more precise than “an extended period”). However, doing so could limit the Fed’s flexibility if conditions change and undermine the Fed’s credibility.
The Fed appears to be settling toward more purchases of long-term securities, but as Bernanke stated on Friday, policymakers will have to consider the potential risks of nonconventional policies. The Fed has a dual mandate of maximum sustainable employment and price stability (which is taken to mean an inflation rate of around 2% per year). While the economy appears to be growing (no sign of a double dip), the Fed is missing on both goals. The Fed is obliged to at least try – and with fiscal policy stimulus seemingly impossible, further monetary accommodation is the only game in town.
There is some fear that in providing further accommodation the Fed will fuel higher inflation in the future and eventually regret it (“maybe not today, maybe not tomorrow, but soon and for the rest of your life,” as Rick Blaine might have said). However, the Fed takes its commitment to low inflation very seriously and officials are confident that policy accommodation can be removed in a timely manner when appropriate.
There are many factors that influence exchange rates. The biggest short-term factor is central bank policies. Increased expectations of further Fed accommodation have recently put downward pressure on the dollar, but it’s unclear how much is already factored into the currency markets. Remember, the Treasury Department speaks for the dollar, not the Federal Reserve (the Fed may intervene in the currency markets, but only on behalf of the Treasury). It’s probably no big secret that the Obama administration, like the previous administration, favors a somewhat weaker dollar over time. It’s one way to reduce global imbalances. What matters for policymakers is the speed of adjustment – too fast, too soon, tends to undermine global trade and finance. China represents the major imbalance. Once again, Treasury has delayed its semiannual report on exchange rate policies. Stay tuned.
Note on economic forecasting: the September retail sales report and August inventory data pointed to stronger GDP growth that seemed likely before these numbers. My estimate of 3Q10 GDP growth went from +1.6% to +2.4%.
(c) Raymond James
