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Will Weak Inflation Derail Normalization?

While the market shows signs of pessimism about interest rate hikes due to relatively slow growth and soft inflation, the Federal Reserve is looking toward additional factors as it anticipates normalizing rates around 3 percent.
Jim Glassman, Head Economist, Commercial Banking
October 25, 2017

Futures markets have long been cautious when it comes to the Federal Reserve’s plans for interest rate normalization. The Fed anticipates raising interest rates to around 3 percent as the economy returns to full strength, but skeptical investors have waited until the last minute before pricing in each incremental interest rate hike in the recent past.

Market concerns about GDP and the overall health of the US economy have likely contributed to this skepticism, as some people view faster growth as necessary for higher interest rates. The economy is likely still headed toward the peak of the business cycle, when near-zero interest rates will no longer support sustainable growth. As such, the Fed’s normalization campaign is likely to continue, regardless of concerns about relatively slow growth and weak inflation.

The Demographics Behind Slow Growth

Throughout the post-recession recovery, relatively sluggish GDP expansion has sparked concerns. The economy has averaged 2 percent annualized growth since the recession, a considerable slowdown from the 20th century annual average of 3.5 percent. This slow growth has led to fears that the recovery is fragile, leaving some analysts to question the economy’s ability to support higher interest rates in the foreseeable future.

But today’s slow growth is not a sign of underlying economic weakness; rather, it is almost certainly the result of the slowing expansion of the workforce as the population ages and the baby boom generation retires. Instead of adding a net 200,000 workers every month, as was common before 2008, the workforce now grows by as few as 75,000 to 100,000 workers monthly.

This demographic trend, coupled with little net immigration over the past decade, has naturally tempered the pace of economic growth. With fewer new workers, overall production cannot rise as quickly. While this unprecedented demographic shift is confusing to investors, it is not a sign of fragility—the economy’s growth rate is only important in comparison with its underlying potential. A demographic-driven slowdown will not prevent the economy from operating at full capacity, and higher interest rates will soon be necessary to sustain growth.

Inflation Isn’t the Only Factor

The Fed is charged with a dual mandate: maintain price stability while promoting full employment. But what happens when neither condition prevails? Currently, the labor market is tightening, and full employment is approaching. Yet prices have remained remarkably unchanged, with the core Consumer Price Index measure of inflation falling well short of the Fed’s official 2 percent target throughout most of 2017.

While this has led some analysts to doubt the Fed’s timetable for raising interest rates, inflation is a volatile signal. It can lag behind developments in the real economy, and the Fed has little direct control over monthly price fluctuations. Interest rate policy is shaped with the intention of creating economic strength in the future and controlling long-term trends, not hitting monthly targets.

Short-term inflation trends can be idiosyncratic, and today’s weak inflationary pressure appears to be driven by supply-side developments rather than a change in demand. The economy is not in distress when prices decline because of a supply windfall—for example, consumers benefited from last year’s global oil glut, as well as the ongoing proliferation of low-cost telecom and computing services. Deflationary pressure is only a concern when it is tied to falling demand, such as when consumers cut back on spending because of widespread layoffs.

This is why the Fed is closely attuned to developments in the labor market. Prices can fluctuate for a variety of reasons that aren’t always clear; as long as layoffs remain historically low and the unemployment rate continues to fall, the Fed is unlikely to shift its course in response to weak price pressure.

Forecasters have taken this lesson to heart. Surveys show that the Fed’s long-term 2 percent inflation target remains credible among professional forecasters. Looking past the monthly noise, the Fed’s true goal is to normalize interest rates gradually in a manner that will maintain stability and support growth as the economy returns to full capacity.

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