After watching highlights of Federal Reserve Chair Janet Yellen’s testimony this week, I realized the Federal Reserve has been slow to relate their change in outlook. In my most recent commentary about the January Federal Reserve meeting minutes, I noted the comment regarding not targeting specific economic indicators. I pointed out this was in reference to the former chair targeting a specific unemployment rate before the Fed would begin raising interest rates. By not mentioning specific parts of the economy, the Fed left open the idea there is a large number of indicators they are watching before committing to a normalization in policy.
During the testimony, Chair Yellen mentioned the Fed was still waiting for inflation to reach the target of 2% and would hold off on raising rates until that target rate was reached. Okay, so it is time to put together another graph showing a few measures of inflation. The CPI for January was just released this week and it was quite alarming, if you are a Federal Reserve committee member. The graph I put together is on the companion site.
The top line on the chart is one of the measures I prefer. It looks at inflation over the past ten years. I prefer this measure because inflation has a tendency to affect consumer’s attitudes for far longer than the extent of it. Yet, this measure has been declining and now sits at 2.05% per year. It is not possible to use this measure against the Fed’s target since they don’t use it and they are more interested in future inflation than past inflation. Also, the momentum of this measure will continue to pull it lower as we move through 2015 since the calculation will be removing 2005.
The next line to discuss is the red line, the one-year inflation rate. When the Bureau of Labor Statistics releases the CPI numbers monthly, this is the headline number they report. Stunningly, the United States crossed over into deflation as the year over year reading was reported at -0.09%. Notice also the momentum of this measure is sharply downward. Unless we see some inflation in the sub-areas, this measure will continue to move lower at least through the middle of summer. There are parts of the press which incorrectly use this reading to compare to the Fed’s target. Again, the Fed doesn’t target historical inflation.
That brings us to the third line, the blue line, which is the five-year forward breakeven inflation rate. There are market instruments that you can invest in which pay interest. These things are real securities. The difference between the prices of these securities results in an implicit guess on where inflation will be in five years. Here are the notes from the St. Louis Fed’s database:
The breakeven inflation rate represents a measure of expected inflation derived from 5-Year Treasury Constant Maturity Securities and 5-Year Treasury Inflation-Indexed Constant Maturity Securities . The latest value implies what market participants expect inflation to be in the next 5 years, on average.
That blue line has also been moving down and currently reads 1.3%. If the market thinks that inflation will be 1.3% per year on average over the next five years, the Fed has the cover to not change rates through at least the middle of the year as indicated in the latest meeting minutes.
And so, it is time to change my expectations. While I would prefer the Fed raise rates in March, I know they won’t. I think they and the Federal government are perpetrating a War on Savers, but it does not matter what I want. The only thing that matters is what the market thinks and the influences upon the market. The Fed has can postpone any rate hike past their current target of June. In fact, I think they can postpone a rate hike into 2016. But wait there’s more — they may not need to raise rates even then. Here’s why:
It starts with the value of the dollar. One of my indicators to watch for 2015 was the value of the dollar. It had just touched a key technical level at the end of 2014 and has moved sharply higher in 2015. When the dollar increases relative to other currencies, the affect is a decrease in the price of imports. By decreasing the price of imports, the inflation rate here drops (largely because we operate with a trade deficit as a result of the reserve currency status of the dollar). Now if the Fed were to raise interest rates, investors from foreign countries would move their funds here to take advantage of the higher interest rates. By doing that, the value of the dollar would continue to rise, causing imports to become even cheaper, and inflation to drop even further.
The problem becomes — raising interest rates will accelerate the deflationary trend in the US. If you read the phrase “importing deflation”, this is what it means. The conclusion I reach is the Fed cannot raise interest rates as long as Japan and Europe, our main trading partners, are aggressively easing their economies through their own quantitative easing programs. Japan may never end theirs and Europe’s isn’t expected to end before September 2016. Thus, no rate increase here until at least then.
The War on Savers continues.