“Importantly, accommodative monetary policy has also helped to offset incipient deflationary pressures and kept inflation from falling even further below the Committee’s 2 percent longer-run objective.”
When he testified before Congress in May, Chairman of the U.S. Federal Reserve Ben Bernanke gave what can be interpreted as a mixed diagnoses of the health of the economy. While economic growth during the first and second quarter continued at a moderate rate, the trajectory of key indicators such as unemployment and inflation are by no means clear.
Due to an increase in the labor-force participation rate, the headline unemployment rate climbed from 7.5 to 7.6 percent in May. This headline rate is significant not only as an indicator of real economic health, but also as the benchmark that the Fed is using as a criteria for a shift in monetary policy. The slight increase is a step away from the Fed’s 6.5 percent target, despite a relatively strong payroll employment increase of 175,000.
The ability of monetary policy to improve long-term labor market conditions has often been called into question. During the May testimony, Chairman of the Joint Economic Committee Congressman Kevin Brady (R-Tex.) asked Bernanke: “My worry is that the Fed doesn’t have the prescription for what ails our economy. A year ago, the Fed said that it wouldn’t set an employment target rate because it’s generally affected by non-monetary factors. But you’re unwinding the QE based on the employment areas that you have the least control of. What do we make of that?”
Bernanke’s response pretty much confirmed Brady’s concern: “What we are trying to address here is the short-run cyclical gap,” he said. “We are seeing the economy operating at a level below what it is capable of operating at, and many people out of work who normally would have work, and monetary policy can help to put people back to work in the short run.”
So, while the Fed has its foot slammed on the monetary gas pedal, it doesn’t really have the ability to bring the economy — at least long-term employment — up to speed. The other side of the Fed equation is inflation, which it arguably has much more power to influence.
At the beginning of 2013, the central bank set a 2.0 percent inflation target with a cap of 2.5 percent as a condition for change in monetary policy. It’s unclear if, at the time, the Fed was worried about the deflationary pressures that have characterized the past few months. Headline indicators have shown little, if any, upward price movement.
“Consumer price inflation has been low,” commented Bernanke. “The price index for personal consumption expenditures rose only 1 percent over the 12 months ending in March, down from about 2-1/4 percent during the previous 12 months. This slow rate of inflation partly reflects recent declines in consumer energy prices, but price inflation for other consumer goods and services has also been subdued.”
Investors have always had one eye glued to inflation because of its effects on interest rates and its broader impact on the purchasing power of consumers. However, because of the Fed’s decision to explicitly include inflation in its thinking about the flow-rate of asset purchases, investors have put the inflationary pipeline under a microscope.
The big questions on the table right now are: when will the Fed taper asset purchases, and what will the wind down look like? Given that speculation about tapering of purchases has caused dramatic market volatility around the world already, many market observers are expecting a significant reaction whenever an actual announcement is made. Tension is high as the Federal Reserve Open Market Committee heads into another meeting next week.
Meanwhile, the markets will take stock of what information is available to them. Besides the headline indicators, investors with an eye on inflation can dig into Friday’s report on the producer price index, released by the Bureau of Labor Statistics. The PPI measures prices changes from the perspective of the seller. The headline index is a gauge of the prices received by producers for a fixed basket of goods. So, although the Consumer Price Index is the core measure of inflation, changes in the PPI index can be used as a leading indicator of pressure in the pipeline.
In May, the PPI for finished goods climbed 0.5 percent, a surprising increase given the softness of the past few months. On the year, the PPI climbed 1.8 percent, or 1.6 percent excluding food and energy. Food and energy are typically volatile, and are stripped out of the core index. Without the two, core PPI rose just 0.1 percent, in line with previous data and expectations.
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