Memo to the Fed: A Roadmap for Inflation

Opinion: Last week, the Federal Reserve finally answered the question investors globally were wondering all year: When will the central bank scale back its $85-billion-a-month bond-buying program and by how much? Answer: starting in January the Fed will cut the amount of bonds it buys per month by $10 billion depending on the strength of the economy.

However, as part of the much-awaited announcement, the Fed said it would keep overnight interest rates near zero until well after the unemployment rate hits 6.5%. The key wording here is “well after.” The Fed previously said it would keep interest rates at historic lows until the unemployment rate hit 6.5% -- not “well after.” The Fed is confident enough in the strength of the labor market to begin curtailing its bond purchases. But it’s worried that inflation is too low. Remember the Fed has two responsibilities: (1) maintain full employment and (2) make sure inflation is kept in check while avoiding painful deflation. Near-zero overnight interest rates target inflation while the bond purchases target unemployment.

The problem is five years of unconventional easy-money policies haven’t spurred inflation, much to critics’ surprise. Inflation is running considerably lower than the Fed’s preferred level of 2%, on a year-to-year basis.

The price index for personal consumption expenditures (PCE) – the Fed’s preferred gauge for inflation – rose a tepid 0.5% in November from October. Consumer prices in November were virtually flat from the prior month, while rising just 1.2% since last November. Meanwhile, prices that businesses pay to make products have declined for three-straight months because of falling energy prices.

Why is inflation so low?

The problem is twofold. First we’re in a liquidity trap. That is, the Fed has injected billions of dollars into the financial system. But banks aren’t lending the money out. Meanwhile, companies are hoarding cash. They’ve taken advantage of low interest rates to refinance debt at lower interest rates and in many instances used the extra cash generated from refinancing debt to buy back stock in their own firms. Companies broadly haven’t used the extra cash to invest in new property and equipment or to hire new workers. That brings up the second problem. Since unemployment remains high, wages aren’t increasing. For real inflation to take root, wages need to increase. Incomes adjusted for inflation are growing less than 1% this year on an annualized basis. That’s less than half the 50-year average income-growth rate of 3.25%. It’s also below already slow growth so far in this four-and-a-half-year anemic economic recovery.

The only place the liquidity is helping is in the stock market, where benchmark averages have zoomed to record highs adjusted for inflation.

So what’s the Fed to do?

One way to spur inflation is to create greater business confidence. That means offering up better, more certain policies from Washington, D.C. A budget deal struck in mid-December that showed bipartisanship from lawmakers for the first time in three years will help. If republicans and democrats can continue to come together and churn out policies, such as corporate tax reform and immigration reform, that would inspire businesses to invest and hire.

Second, the Fed is paying banks 0.25% interest on excess reserves kept at the central bank. That encourages banks to keep money at the central bank instead of loaning it out. Can you blame them? Instead of taking on the risk of investing in short-term securities that pay next to nothing or making loans, banks get interest with zero risk. But banks are in much better shape since the doldrums of the financial crisis. They don’t need to be paid interest on excess deposits at this point. The Fed should not offer any interest on excess reserves. The central bank could also begin charging banks to hold money there. That would force banks to start lending out more or at least invest the extra cash in short-term securities.

That’s the ticket to higher inflation.