Federal Reserve Dilemma Suggests Higher Inflation

The economy looks like it has momentum as of the beginning of 2018 based on most indicators. For example, retail sales growth was 5.4% in December and 4.2% for all of 2017 which was up from the 3.2% growth in 2016. However, retail sales in January declined 0.3% compared with a growth of 3.6% a year earlier. Small business optimism in 2017 was the highest in the 45 years of the NFIB survey. The stock market kept hitting record highs throughout January as corporate earnings growth was solid. Finally, inflation has been increasing. The core inflation is at 1.8% for both the months of December and January. Core inflation has primarily been below the Fed’s 2% inflation target since it was set in 2012.

In December 2017 Core Inflation Was 1.8%

The Fed Stuck With Low Rates

Even though growth has been strong in the past 12 months, the Fed isn’t satisfied. In fact, the Fed is considering changing policy because it is so concerned about the future. The catalyst for this nervousness is the low inflation we showed in the chart above. This is disconcerting for the Fed because it wants to raise rates high enough to be in the position to cut them significantly in the next recession. The low rates are another reason why Yellen was so dismissive of the signal an inverted yield curve would suggest for the probability of a recession occurring. She doesn’t want a recession soon because the Fed is still at a Fed funds rate between 1.25% and 1.5%. The chart below shows how much the Fed cut rates in the past few recessions.

Fed Eases 5% On Average During Recessions

The average percentage of cuts is 5%. The lowest cut percentage was 2.1% meaning if a recession happened now, there wouldn’t be room to cut that amount unless the Fed went below the zero bound which is theoretical and practical lunacy.

While our example of a recession occurring now is unrealistic, one occurring in a few years is probable. The expected Fed funds rate in 2020 is 3.125% and the long run expectation is somewhere between 2.75% and 3%. The Fed blames the low rates on the low neutral rate. We’ve discussed the neutral rate in the past. It’s the interest rate where GDP grows at its long term trend and inflation is stable. Keep in mind, this rate is an opinion. Some see low neutral rates caused by the aging demographics in the developed world. Regardless of the cause of these low rates, the Fed is in a quandary because rates won’t have much room to be cut. In fact, a research paper showed that the Fed funds rate is going to be at 0% for 30-40% of the time with the current policy prescription.