FOMC Chair Yellen on inflation and policy

Following on from the post-September FOMC meeting communications (which gave a great deal more weight to global conditions than had been expected), Chair Yellen turned the focus back to domestic issues overnight in an address titled "Inflation Dynamics and Monetary Policy". There was no Q&A.

The discussion initially turned to the history of inflation in the US and a theoretical explanation of its potential costs. For episodes of persistently weak inflation, the concerns were clear. Chief among them is that a protracted period of inflation well below target "constrains a central bank's ability to combat recessions". Specifically, the nominal Fed Funds Rate can only be pushed to zero; and its real equivalent can only fall below the lower bound by the rate of inflation. The inflation pulse therefore has an immediate impact on the real stance of policy, and as such, the effectiveness of the central bank in supporting a recovery.

Also of note is the linkage between inflation and wages and the consequence for debt repayment. Weak inflation, particularly at a time of significant labour market slack, materially hinders nominal wage growth. This makes it that much harder for households to pay down existing debt, limiting their discretionary spending capacity. In said circumstances, households are also at risk of experiencing a loss of wealth, should asset prices also decline. These concerns explain why FOMC members are so reticent to begin hiking rates while annual inflation remains near zero - despite the unemployment rate having fallen to a level near full employment. 

Apparent in Chair Yellen's remarks was a strong belief that inflation expectations form the basis for actual inflation over the long-term. Chair Yellen noted that expectations have been resilient following the GFC, with the long-term trend for professional forecasters broadly in line with the FOMC's 2.0% target, and household's expectations stable above that mark. This result is the cornerstone of the Committee's belief that their medium-term inflation target can be achieved under appropriate policy.

Based on estimates provided by Chair Yellen in her address, whereas 'economic slack' was the dominant factor behind inflation's disappointment through 2008-13, its effect has since dissipated. Instead, weak relative energy prices were the prime determinant in 2014; while in 2015, import prices were an additional burden. 

Both of these latter factors are seen as transitory and, given historical lags, are already likely abating. Consequently, with the unemployment rate near full employment, the opportune time for a first hike is near. While disappointed by the FOMC in September, the first move will be made before year end; this position received significant support in Chair Yellen's concluding remarks overnight. "Most FOMC participants, including myself, currently anticipate that achieving these conditions will likely entail an initial increase in the federal funds rate later this year" is as clear a statement of intent as is possible and comes despite lingering uncertainties about the global economy and financial markets. Of course, it is the path of rates thereafter that will dictate financial conditions; how "gradual" this will be will only be known in time, with data and market outcomes to dictate.