Central Banks

With general agreement on the part of FOMC members that the labor market is operating near or at full employment, the eyes of followers thus shifts to what they think about inflation. My head is spinning on the commentary and I just can’t understand the obsession of 2%. The FOMC minutes said “Many participants judged that much of the recent softness in core inflation reflected temporary or idiosyncratic factors and that inflation would begin to rise once the influence of these factors began to wane.” As some have specifically cited low cell phone bills as a factor, they thus want your cell phone bills to get more expensive. They also said “Most participants continued to think that the cyclical pressures associated with a tightening labor market were likely to show through to higher inflation over the medium term.” The underline is mine.

That said, “many participants observed that there was some likelihood that inflation might remain below 2% for longer than they currently expected (god forbid), and they discussed possible reasons for the recent shortfall.” They bandied about different possibilities with a key one including “the effect of technological innovation in disrupting existing business models.” What they don’t acknowledge is that this has always been the case and its very typical that over time goods prices go down.

They went on, “several participants expressed concern that the persistently weak inflation data could lead to a decline in longer term inflation expectations or may have done so already.” Market inflation expectations as measured in the TIPS however are little changed vs where they were last year.

Here is where it gets really dizzying to read: “Many participants observed, however, that continued low readings on inflation, which had occurred even as the labor market tightened, might reflect not only transitory factors, but also the influence of developments that could prove more persistent. A number of these participants were worried that a decline in longer-term inflation expectations would make it more challenging for the Committee to promote a return of inflation to 2 percent over the medium term. These participants’ concerns were sharpened by the apparently weak responsiveness of inflation to resource utilization and the low level of the neutral interest rate, and such considerations suggested that the removal of policy accommodation should be quite gradual.”

BUT, “In contrast, some other participants were concerned about upside risks to inflation in an environment in which the economy had reached full employment and the labor market was projected to tighten further, or about still very accommodative financial conditions. They cautioned that waiting too long to remove accommodation, or removing accommodation too slowly, could result in a substantial overshoot of the maximum sustainable level of employment that would likely be costly to reverse or could lead to increased risks to financial stability. A few of these participants emphasized that the lags in the response of inflation to tightening resource utilization implied that there could be increasing upside risks to inflation as the labor market tightened further.”

‘Many’ sounds like more than ‘some’ and why this is just another dovish commentary.

They said this on asset prices, “In light of elevated asset valuations and low financial market volatility, several participants expressed concerns about a potential buildup of financial imbalances. They worried that a sharp reversal in asset prices could have damaging effects on the economy. It was noted, however, that elevated asset prices could be partly explained by a low neutral rate of interest.” So they basically admit that low rates juiced asset prices and now they are worried about it but won’t do anything about it because they are worried about a fall which would damage the economy.

Bottom line, expect a continued slow pace of rate hikes where 3 per year certainly qualifies and they’ll stop when something breaks as it typically does. Greenspan was on a run rate of 8 per year. While some are mystified why inflation is below 2%, I highlight a key factor is suppressed healthcare costs in the PCE because of government price fixing. On the generally dovish commentary, as usual, the 2 yr note yield is down to 1.73% but the 2s/10s spread is still at a decade flat at 59 bps. The dollar is at the low of the day and gold is at the high of the day.