On the one hand
Inflation is rising, but households have yet to notice
IT IS a tough time to be a central banker. On March 8th the IMF called for more stimulus globally to see off a lack of demand in the world economy. On the same day economists at the Peterson Institute, a think-tank, issued a report that was labelled a “reality check”, arguing that fears for the world economy were overblown. (One of the report’s authors, Olivier Blanchard, was until last year the IMF’s chief economist.) The disagreement reflects conflicting signals that the Federal Reserve must untangle at its next meeting, which begins on March 15th.
When the Fed raised interest rates by a quarter-point in December, after seven years without a change, inflation was still in the doldrums. According to the central bank’s preferred measure, prices were rising by just 0.5% a year. The Fed raised rates anyway: Janet Yellen, its chair, argued that the fizzing labour market meant inflation must be on the way. Waiting for it to arrive before raising rates might force the Fed to yank them up abruptly later, potentially triggering a recession. Crucially, households’ inflation expectations had not fallen much, so the Fed could argue that its 2% inflation target remained credible even as it tightened policy.
Since “lift-off” in December, worries about the global economy have sent stockmarkets sliding.
The S&P 500 has fallen by about 5% since then; in the gloomiest moment in February, it was 12% down. But America’s labour market has not been gyrating in the same way. In February the economy created 242,000 jobs, many more than the roughly 100,000 thought to be needed to stop unemployment rising.
What is more, Ms Yellen’s prediction is beginning to come true. Core inflation, which excludes food and energy prices, was 1.7% in January, its highest level since 2013. The headline measure has risen too, to 1.3%—still well below target, but a marked increase nonetheless. Rate-setters are likely to raise their forecasts for core inflation at their meeting this month, according to Zach Pandl of Goldman Sachs.
But not every measure is following Ms Yellen’s script. According to the University of Michigan’s survey of consumers, Americans’ inflation expectations have dipped to 2.5%. Although that is above the Fed’s target, consumers usually predict inflation that is higher still. Their expectations today are 0.5 percentage points below their long-term average, and as low as they have been since 2010.
Consumers may have only now adapted to a world of cheap fuel and a strong dollar. If so, rising inflation should gradually turn their forecasts around. But measures of inflation expectations in financial markets—usually thought of as more forward-looking than consumers—have been depressed for some time. The difference between yields on inflation-protected government bonds and the normal kind points to inflation of just 1.4% over the next five years. (This measure also rallied in the second half of February, having previously dipped below 1%, its lowest level since the crisis.)
Ms Yellen is sceptical of these barometers. The market for inflation-protected bonds is less liquid than before the financial crisis. That means investors might demand a higher return to hold these bonds rather than regular ones, compressing the spread between the two. The “inflation-risk premium”, which investors demand to insure themselves against very high levels of inflation, may also have come down (this can happen without the mean forecast for inflation changing). It is unlikely, though, that such factors fully account for investors’ apparent nonchalance about inflation.
The swaps market, which suffers less from such problems, points to medium-term inflation of around 1.7%. Markets, it seems, think the likely path of monetary policy is too tight.
Yet Americans continue to spend strongly, as Mr Blanchard and his colleagues point out. Incomes and spending both rose by a robust 0.5% in January. Retail sales are strong.
In December most rate-setters forecast another interest-rate rise at the coming meeting. That now looks very unlikely, thanks to the gloomy global picture. But the Fed may be in the curious position of marking up its inflation forecasts even as it postpones rate rises. The recent financial volatility, which could be a sign of problems to come, justifies the change of heart. But with the domestic economy purring, it would not take much of a climb in the oil price, or a fall in the dollar, to push inflation higher still. Markets expect only one interest-rate rise this year, and only three more rises by the end of 2018. They are probably underestimating.