Fed Fears Falling ‘Flation

Jon Hilsenrath said it all today (Sunday) in his WSJ article about the FOMC meeting scheduled for this week:

"Federal Reserve officials are likely to continue their easy-money policies at the central bank's policy meeting on Tuesday and Wednesday, in part because several recent inflation measures have fallen well below the Fed's 2% target."

That’s a relatively new development. Until recently, Fed officials said that their ultra-easy monetary policy was necessary to reduce the unemployment rate to 6.5%. They said that they would pursue this course as long as inflation didn’t rise more than 50bps above their 2% inflation target. Now they seem to be thinking that with inflation heading below rather than above this mark, there’s all the more reason to stay with the easing course.

Over the past few weeks, the members of the "Federal Open Mouth Committee" were mostly chattering about how they might phase out QE if the labor market continued to improve. They did so at the last meeting of the FOMC on March 19-20. Then, on April 5, March payrolls showed a gain of only 88,000. Now the moderation in the latest inflation data only strengthens the hand of the FOMC’s doves.

In his article, Hilsenrath noted that top Fed officials recently have suggested that they are concerned about the recent decline in inflation. They said that if it persists, then they will favor proceeding with the current bond buying program or even increasing it.

The core PCED inflation rate fell in March to 1.1% y/y, the lowest since March 2011 (Fig. 2). I don’t understand why Fed officials are so convinced that lower inflation is a bad thing. They obviously view it as a sign of economic weakness. They also seem to fear that falling inflation will hurt demand for goods and services by eliminating buy-in-advance attitudes.

Are they aware that much of inflation’s recent improvement (IMHO) is attributable to health care costs? That’s right: The PCED medical care inflation rate was down to 1.7% in March, the lowest since April 1998 (Fig. 3). There have been significant drops in inflation rates for drugs and physician fees (Fig. 4). Does the Fed want to see higher inflation rates in the health care industry so that people will rush to buy medical care goods and services before their prices go up?

Rent inflation has rebounded during the current economic recovery, but now shows signs of peaking (Fig. 5). The CPI and PCED data are nearly identical and show that rent of shelter is up 2.2% y/y. It was actually falling during 2010. It accounts for 17% of the core PCED and 42% of the core CPI. Do Fed officials really want still higher rent inflation?

Do they know what they want? It doesn’t matter to the stock bulls. If the members of the FOMC now believe that both the unemployment and inflation components of their dual mandate oblige them to maintain QE and even to increase it, so be it. QE may be losing its effectiveness in boosting the economy and inflation, but that just leaves more liquidity to float stock prices higher (Fig. 6).

(Based on an excerpt from YRI Morning Briefing)