Easy Money Not Adding Up To Inflation

What happens when the Federal Reserve keeps interest rates at nearly zero for more than four years and simultaneously buys trillions of dollars worth of bonds to pump liquidity into capital markets? Runaway inflation, right?

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Wrong. Try the opposite. In fact, by some important gauges inflation has recently fallen below levels deemed desirable by the Fed.

The Fed believes a steady 2% annual inflation rate is a sign that wages and demand for goods are rising, two positive measures of economic growth. Anything below that level suggests wages and demand are stagnant, both of which represent drags on economic growth.

The Commerce Department said last week that its personal consumption expenditure price index, an important barometer of consumer price inflation, had risen just 1.2% from a year earlier, well below the Fed’s 2% target.

“It’s a bit of a phenomenon here in the U.S.”

Peter Cardillo, Rockwell Global Capital

Meanwhile, at the other end of the spectrum, the Fed has said inflation will have to rise to 2.5% annually before Fed policy makers will consider raising interest rates or curtailing its $85 billion per month bond buying program, known as quantitative easing.

Of course other factors could sway the Fed to consider scaling back bond purchases, factors such as consistently strong labor reports. But that hasn’t happened and isn’t likely to any time soon. The April jobs report due on Friday is widely expected to show the unemployment rate held steady at 7.6% from a month earlier.

So in all likelihood the Fed will stand pat Wednesday at the end of two days of Federal Open Market Committee meetings, at which most monetary policy is set.

“It’s a bit of a phenomenon here in the U.S.,” said Peter Cardillo, chief market economist at Rockwell Global Capital, referring to the declining inflation levels despite the Fed’s lengthy easy money policies. “But it’s feeding off global deflation signs.”

In other words, the lousy global economy is keeping prices depressed just about everywhere.

Until recently, that wasn’t the case. Energy and food prices, which are usually excluded from so-called core inflationary measures because they tend to be more volatile than other consumer goods, were sharply higher as recently as late 2012.

But commodity prices have plummeted nearly across-the-board in recent months as global demand has weakened. Crude oil prices have fallen 10% from a year ago, gold is down about the same amount, and silver and corn have also tumbled in value. Only natural gas prices have spiked in recent months, and that sharp increase is viewed as an anomaly by energy analysts.

With weak global demand, U.S. export prices have remained stagnant. “You can’t raise export prices here in the U.S. because of the weakening global economic activity,” Cardillo explained.

Inflation Inextricably Tied to Labor Markets

One of the more interesting aspects of declining inflation is that it was just a month ago, at the Fed’s last meeting of the FOMC, that Fed inflation hawks were calling for gradually scaling back bond purchases because housing and labor markets seemed to be gaining some traction.

With the economy ostensibly improving, all that easy money would inevitably lead to inflation. Or so the thinking went.

But then came the disappointing March jobs report, which revealed just 88,000 jobs created that month, and more turbulence in Europe, where severe austerity measures in some countries have led to soaring unemployment rates.

Now FOMC members are suggesting that bond purchases could be increased if inflation continues to fall. James Bullard, president of the Federal Reserve Bank of St. Louis, told The Wall Street Journal that additional bond purchases are an option if inflation levels continue to decline.

The question going forward then is what will have to happen to turn those inflation numbers around to such an extent that the numbers start moving higher, at some point prompting Fed officials to turn off the easy money spigot.

Gus Faucher, senior economist at PNC Financial Services Group in Pittsburgh, said current inflation rates are inextricably tied to labor markets.

Faucher noted that the employer cost index rose just 0.3% during the first quarter, according to Labor Department statistics released Tuesday. Wages and salaries climbed just 0.5% during the first quarter and benefits were up only 0.1%, marking the poorest gains since the first quarter of 1999. All of which pushed down demand for consumer goods and contributed to the lower inflation numbers.

“We’ve seen very weak wage growth and demand is soft overall in the U.S.,” said Faucher.

Inflation will only start to tick higher when unemployment begins to drop significantly,Faucher explained, probably to about 6.5%, the same level targeted by the Fed as a point where bond purchases will be cut off and interest rates will start to move higher.

“Once we see unemployment drop to around a 6.5% level then we’ll see wage pressure start to build and inflation levels will follow,” said Faucher.

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