December 6, 2013

Janet Yellen’s inaugural challenge

October’s inflation rate in the United States was only +1.0%, according to the Bureau of Labor Statistics.

That was a drop from September’s year-over-year increase in the all-items Consumer Price Index (CPI) of +1.2%.

The “core” rate of increase, which omits food and energy, was more robust in the latest month at +1.7%. The average for the core rate so far this year has been +1.8%.

Central bankers like to see an inflation rate close to +2.0%. Some inflation is good for the economy since it allows firms to raise prices and earn more profits. It also effectively lowers the cost of borrowing.

With a relatively minor degree of inflation (i.e., +2.0%), repayments on loans of a fixed dollar amount become less onerous over time.

There is concern in many parts of the world that prices aren’t increasing fast enough. Nobody in authority wants deflation (i.e., a general level of prices that is moving downwards). When prices are falling, consumers put off purchases in the hopes they’ll get a better bargain down the road.

The headline inflation rate has been as high as +2.0% on only two occasions this year, in July and February. Both months were exactly at the benchmark.

In the latest U.S. inflation report, energy prices year-over-year were -4.8%.

Included within that number was a drop of 10.1% in the cost of gasoline. That’s quite a reversal from what drivers have come to expect. Too often, in the past, they’ve been surprised by a hike in the price at the pump.

The one-tenth petrol price decline presents an opportunity to spend money in other areas, say on presents for the holiday season, like the recent Thanksgiving Day and Black Friday — the timing could hardly be more favorable.

October’s U.S. retail sales report has also just been issued, by the Census Bureau, and it records a month-to-month change of +0.4% in current (i.e., unadjusted for inflation) dollars.

Versus October of last year, shopkeepers’ revenue is +3.9%. The benchmark for full-on vitality in this sector is +5.0% or higher year-over-year.

With the economy performing hesitantly and inflation staying weak, the Federal Reserve has neither the wish nor the need to nudge up interest rates.

But the Fed is faced with a dilemma. There is increasing speculation that its $85 billion per month bond-buying program may be causing serious fault lines in the economy.

While the slack labour market and fierce competition among retailers are combining to keep inflation in check, the surfeit of money provided by the Fed is coursing through the economy and perhaps driving up some asset prices.

Housing starts remain far below their historical average, an indication that demand hasn’t yet caught up to where it should be.

Nevertheless, existing home prices have been moving up at a double-digit percentage rate. It can be argued that this is happening simply as a result of the mathematics — i.e., any increase on a low base, such as occurs in a trough, will lead to a higher percentage change.

Furthermore, a “true” bubble — which is to say, the “usual definition” of a bubble — in house prices isn’t likely until the overall market is much healthier.

However, keep in mind that with a nearly non-existent official interest rate and exceptional pump priming (i.e., the printing of money), the U.S. economy is trekking through unexplored territory.

It’s not as easy to dismiss what is happening in stock markets. The DJI, S&P 500 and NASDAQ are all burning rubber as they accelerate to new heights.

The first two keep re-setting all-time peaks, while the latter is almost back to its year-2000 summit.

This is happening while employment has yet to match its pre-recession level, the nation’s overall jobless rate (7.3%) is unacceptably high and gross domestic product growth (GDP) is underperforming versus full capacity, which is usually judged to be around +3.5%.

It’s a given that one of the Fed’s two primary monetary tools will stay firmly in place for a good deal longer. The business sector has already been assured the federal funds rate will be kept near zero percent (i.e., in a range between 0.00% and 0.25%) until at least the middle of 2015.

Ongoing usage of the second weapon is what’s being called into question.

To avoid criticism that its other emergency policy is leading to distortions, the Fed would dearly love to reduce, in graduated stages, its outsized level of bond purchases.

But such a course of action would have consequences for a range of interest rates not directly tied to the federal funds rate.

Fewer government bond purchases would mean a lowering of demand, leading to weaker prices.

In the bond market, there is an immutable inverse relationship between price and yield.

Interest rates for treasury bills, for instance, would climb — with a spillover impact on rates charged for mortgages.

Provided she achieves clear passage through the nomination process, Janet Yellen will be taking over from Ben Bernanke as Chairman of the Fed at the beginning of February next year.

She must already be thinking long and hard about her challenge — how to attempt a withdrawal from excessive Federal Reserve stimulus while leaving the general level of interest rates as untouched as possible.

Under the current circumstances, the usual well-wishes that are extended to someone taking on new responsibilities in a difficult management position will be even more heartfelt in the instance of Ms. Yellen’s promotion.

For more articles by Alex Carrick on the Canadian and U.S. economies, please see his market insights. Mr. Carrick also has an economics blog.

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