Is the Fed Fighting Deflation?

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With U.S. monetary policy in the spotlight, many investors have their eyes glued to the same economic indicators that the U.S. Federal Reserve is watching: unemployment and inflation, both of which are meandering toward targets established earlier in the year. Unemployment is trending lower and inflation is trending higher, and according to Fed projections, the economy looks as if it is one to two years away from a reasonable definition of “healthy.”

But the implications of different economic indicators over the past several months have bled together and painted a fairly gray picture of the U.S. economy. Consensus estimates from Fed policymakers suggest that while conditions may be improving, the data have no shortage of modesty.

The most recent Employment Situation report, for example, showed a 0.1 percentage point decrease in the headline unemployment rate to 7.3 percent, but also showed a further decline in the labor force participation rate and little change in the level of long-term unemployed.

Gross domestic product grew faster in the second quarter than economists had anticipated, at +2.5 percent, but it followed downwardly revised growth of 1.1 percent in the first quarter. Measures of consumer spending and consumer confidence by Gallup have also come in weak over the past two months, falling from highs in May. Gallup’s consumer confidence index was at -14 as of Tuesday.

Complicating the recovery is this: despite the Fed’s massive and ongoing asset purchase program, the economy isn’t heating up as much as some economists would like. On Thursday, for example, the Bureau of Labor Statistics reported that export prices fell 0.5 percent on the month in August, while import prices were flat. This compares against expectations for a 0.1 percent increase in export prices and a 0.5 percent increase in import prices.

Import and export price movement is not a core part of the deflationary argument, but it is icing on the cake. Combined with low or negative price movement in other indicators like the producer price index, inflation — instead of unemployment — may be where the Fed focuses its attention during the next Federal Open Market Committee meeting. Minutes from previous meetings show increasing concerns about deflationary pressures among some Fed members.

In a testimony before Congress earlier in the year, Bernanke argued that “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.” The comment underscored an increase in the personal consumption expenditures index — the Fed’s favored inflation indicator — of just 1 percent over the past 12 months.

The recent import and export price data suggest that there may be more deflationary pressure present than desired.


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