Inflation is Not the Fed's Main Concern, it's Quantitative Easing

U.S. consumer prices moderated slightly in September as the edge came off rental and energy costs.  The annual consumer price index fell to 2.3 percent from 2.7 percent in August and the core rate remained at 2.2 percent. On Wednesday core producer prices were reported to have risen 2.5 percent percent in September up from 2.3 percent prior.

The core personal consumption expenditure price index (PCE), the Fed's chosen measure, was stable at 2 percent in August for the fourth consecutive month.

Traditionally and by assertion inflation is the Fed's first economic target. The Fed's main rationale for the extended experiment with quantitative easing in the aftermath of the financial crisis was to thwart deflation.

With the core CPI and core PCE rates as above and the 12 month moving averages at 2.03 percent and 1.79 percent respectively the Fed can be fairly said to have achieved its 2 percent inflation goal.  

Treasury yields have blunted their six week surge after the 10-Year reached 3.26 percent on Tuesday, the highest for this benchmark rate in seven years.  The 10-Year was returning 3.12 percent late in the New York afternoon on Thursday, down four points from Wednesday's close.

The Fed raised its base rate 25 basis points in September to 2.25 percent, the eighth increase this cycle and by its own projections expects four more hikes to the end of 2019. 

Pricing pressures do not appear to be building in the economy despite the 4.2 percent growth in the second and third quarters (GDPNow forecast). Though the core producer price index was at 2.5 percent in September with a 2.45 percent 12 month moving average this higher rate is not moving into retail prices where firms largely lack extensive pricing power, restrained, among other reasons by the global sourcing economy.

Wage growth has also remained quiescent. Average annual earnings were 2.8 percent higher in September, down from August’s nine year high at 2.9 percent. Wages have been moving fitfully higher for much of the past three years. But the 2.68 percent 12 month moving average in September is well below the 3-3.3 percent range of 2008 and early 2009. Much as firms have structural impediments to freer pricing so are wages inhibited by the large pool of unemployed workers represented by the 62.7 percent labor force participation rate. 

The Fed governors’ and Chairman Powell’s determination to keep the Fed Funds and market rates moving higher is not set by concerns that prices and expectations are escaping their grasp. While inflationary pressures have historically accompanied the farther reaches of an economic expansion that is not the case now. Having recently defeated the much more serious threat of deflation inflationary expectations for both consumers and businesses are, as the Fed puts it, ‘well anchored’.

Fed interest rate concerns are rooted in economic history. In the last three recessions, 1990-91, 2001 and 2008-09, the Fed cut the base rate 675 basis points, 550 basis points and 500 basis points, that is 6.75 percent, 5.5 percent and 5 percent.  The Fed Funds rate at the start of each cycle was 9.75 percent, 6.5 percent and 5.25 percent.

Even given the declining overall rate structure of the past 30 years, a reduction of 300 points to a 0.25 percent upper target, all that would be available in December 2019, is probably too little to ease the economy through a recession. The Fed’s own projections anticipate only one more increase to cover a median Fed Funds rate of 3.4 percent, through the end of 2021.  

Will a maxium of 325 points of rate reductions from a Fed Funds rate of 3.5 percent be sufficient if a recession strikes in the next three years?  The situation is clear, though unstated. The Fed’s own forecasts imply a return to quantitative easing in the next recession. It is to mitigate that recourse that the Fed will keep rates moving higher. 

Charts: Reuters Eikon