Inflation Replacing Unemployment as Fed Barometer

Inflation is emerging as the new unemployment, and 2% is replacing 6.5% as the threshold target investors, analysts and economists will be watching in 2014.

Judging from policy statements released in recent weeks by the Federal Reserve and public comments from various Fed members, the central bank has begun shifting its attention away from long-held concerns for a stubbornly high unemployment rate and toward an inexplicably low inflation rate.

For months the Fed has targeted 6.5% unemployment as a threshold for raising the key fed funds interest rate above its current near-zero level, where it was lowered in December 2008 during the height of the financial crisis.

The 6.5% jobless threshold had been held out as a target that would provide evidence the economy was healing and ready to begin standing on its own without the unprecedented stimulus policies initiated by the Fed in the wake of the crisis.

But a funny thing has happened on the way to 6.5%.

The inflation rate, which was supposed to soar as a result of all those trillions of easy Fed dollars pumped into the financial system in the past five years, has lingered at about 1%, or half the Fed’s target of 2%.

At a Loss to Explain Low Inflation

Not only have Fed officials been at a loss to explain why inflation has remained so low, there is considerable disagreement among monetary policy makers over whether low inflation is now the primary concern or whether long-predicted runaway inflation remains the real threat to economic recovery.

The central bank’s 2% target inflation rate is designed as a middle ground between prices rising too high and too fast and prices falling too quickly, the latter a situation known as deflation.

Inflation occurs when wages are rising along with demand for goods, which pushes prices higher. So a little inflation -- say a 2% rate -- is good because it means wages are going up and there’s solid demand for stuff, but prices aren’t rising too fast that they become unaffordable. Too much inflation means prices are rising faster than wages, which makes it hard for households to balance their checkbooks.

Deflation occurs when not enough demand for goods causes prices to fall. The current 1% inflation rate is a sign to some that the ongoing economic recovery remains weak and that the Fed should think twice before moving too quickly away from easy money.

Menzie Chinn, an economist at the University of Wisconsin-Madison, explained why deflation is cause for worry.

“Unexpected deflation means that the real value of debt held by households and firms increases,” he said.

Deflation Makes Debt More Expensive

In other words, while the value of goods and wages is declining the costs for households and firms to pay back long-term debts such as fixed-rate mortgages does not, which makes that debt more expensive to pay down.

As the value of that debt rises a domino effect occurs in which companies “forego investment in new plant and equipment, or don’t hire more workers, or both. This feeds into the general economy in the form of less income, so less spending by households occurs, and on down the line,” Chinn explained.

Another reason deflation is worrisome is that when prices are falling businesses and consumers tend to defer purchases, hoping prices will fall even further. That reduction in consumption translates directly into weaker demand, which contributes directly to the vicious cycle of deflation by causing prices to fall even further.

Fed policy makers of all stripes would prefer to see inflation rise from its current low level to that 2% sweet spot before the central bank accelerates its gradual transition away from easy money and back to a policy of normalcy.

Consequently, as the unemployment rate has ticked lower toward that 6.5% threshold (it fell to 6.7% in December) -- and not necessarily for reasons hoped for by the Fed -- the 2% inflation target has grown in significance.

Gary Thayer, chief macro strategist at Wells Fargo Advisors, said policy makers who have raised concerns about deflation are doing so to warn against the Fed moving too quickly away from its stimulus policies.

Neither Runaway Inflation nor Deflation are Imminent Threats

The policy-setting Federal Open Market Committee voted last month to begin gradually tapering its monthly bond purchases, starting with a $10-billion-a-month reduction in January. Tapering is expected to push some long-term interest rates such as mortgages higher, which could negatively impact the housing sector, throwing up another obstacle to a full recovery.

Thayer said he supports the Fed’s current strategy of gradual tapering as opposed to the central bank’s two previous bond purchase programs which ended all at once.

“I think this tapering gives the Fed more flexibility,” he said.

Thayer said he doesn’t see either deflation or runway inflation as imminent threats. Harmful deflation is unlikely because the U.S. economy appears to be steadily recovering and many Americans have paid down big debt loads since the financial crisis.

Meanwhile, runaway inflation hasn’t emerged as a threat because slow global economic growth, especially outside the U.S., has tamped down demand, which has kept commodity prices low and the value of the dollar weak.

For now, anyway, the consensus among Fed policy makers -- led by incoming Fed Chief Janet Yellen -- is that inflation will rise gradually back to that 2% target, possibly by the end of 2014 or early next year. A lot of people will be watching.