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Economic Insights

The U.S. Federal Reserve likely will stand pat on policy next year as long as its preferred inflation gauge remains near its target.

The key flavors of the U.S. Federal Reserve’s (Fed) preferred price index—the PCE deflator1—have dropped below the central bank’s 2% target in 2019 and have receded even further below it in recent months. This has revived concerns that inflation expectations could become de-anchored from that target and led to a suspicion that the Fed’s inflation marker is viewed as a ceiling, leading to a downward bias in actual inflation.

 

Advisors: Giulio Martini and other Lord Abbett experts will tackle prospects for U.S. Federal Reserve policy and other key topics during our 2020 Investment Outlook Webinar on January 8, 2020. Register now.

 

Fed policymakers of all stripes have insisted that the target is symmetric and that they would tolerate a period of above 2% inflation to make up for prior shortfalls. They have backed this up with a full-fledged review of the inflation-targeting framework that is expected to enshrine some version of symmetry in the form of a new operating procedure. It is expected this change will be announced sometime in 2020.

In the meantime, despite some indications that inflation is not decelerating as much as the PCE deflators suggest, the Fed is likely to remain on hold, with a bias towards easing, for all of 2020.

 

Chart 1. The U.S. Federal Reserve’s Favored Inflation Indicator Remains below Its 2% Target
U.S. PCE deflator (all items and ex-food and energy), January 31, 2001-October 31, 2019

Source: U.S. Bureau of Labor Statistics. Data as of October 31, 2019.

 

One way to understand how inflation has remained so low despite the United States entering the 10th year of an economic expansion is to divide prices into cyclical and non-cyclical components. The former are driven by factors such as how tight the labor market is, capacity utilization, and the strength of demand while the latter are driven by longer-term technical change and structural forces. This decomposition shows that the non-cyclical components have decelerated sharply over the past year while the cyclical components have accelerated only gradually. The end result: lower inflation overall even as gross domestic product (GDP) growth continues above trend.

 

Chart 2. Cyclical and Non-Cyclical Data Offer Clues as to Why U.S. Inflation Remains Low amid Continued Growth
Cyclical and non-cyclical components of the U.S. consumer price index, January 1, 2000-September 30, 2019

Source: U.S. Federal Reserve Bank of San Francisco. Data as of September 30, 2019.

 

A more robust version of the PCE deflator produced by the U.S. Federal Reserve Bank of Dallas shows that inflation has been stable at right around 2%, with a downward tendency in recent months. Meanwhile, the U.S. Federal Reserve Bank of New York’s underlying inflation gauge—which uses a statistical procedure to extract an underlying common inflation component from a very broad set of price indexes—has also been stable at right around 2% in recent months.

While the policy-setting Federal Open Market Committee (FOMC) does review these alternative inflation gauges, it has made it clear that it is not playing three-card monte2 when it comes to inflation objectives; it is sticking with the published PCE deflator rather than highlighting alternative formulations to justify tightening or standing pat when many observers believe it should be easing. Thus, while the Fed may eventually fall “behind the curve” in terms of raising short-term rates, it seems to feel that may be necessary in order to maintain credibility for monetary policy in the broader sense. (We will have more to say about the inflation question in an upcoming edition of our podcast series, The Investment Conversation.)

Moreover, in an environment of elevated uncertainty the FOMC appears to be downgrading the importance of forecasts and upgrading the importance of data in hand. This also supports waiting longer to tighten than would otherwise be the case. The current policy framework has diverged from the one that resulted in eight different tightening actions in 2017-2018 in favor of an approach to monetary policy that should support risk-taking as long as inflation only accelerates gradually, and the Fed signals that’s okay. If the Fed remains on the policy sidelines in 2020, we believe one of the major obstacles to risk asset prices rising further will have been removed.

 

1 The Personal Consumption Expenditure price index (PCE), also referred to as the PCE deflator, is a United States-wide indicator of the average increase in prices for all domestic personal consumption. It is benchmarked to a base of 2009 = 100. Using a variety of data including U.S. Consumer Price Index and Producer Price Index prices, it is derived from personal consumption expenditures, the largest component of U.S. gross domestic product in the U.S. Bureau of Economic Analysis’ National Income and Product Accounts report.

2A putative game of chance long familiar to tourists and police officers in urban areas, three-card monte involves a player (or “mark,” depending on your point of view) attempting to find the "money card" among three face-down playing cards arranged by the dealer.

 

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