Optimistic Fed Gives Nod to Rising Inflation
The more things change, the more they stay the same, at least when it comes to predictions from the Federal Reserve’s Federal Open Market Committee.
In the wake of this week’s meeting, FOMC members remain optimistic, but admitted that anticipated progress will be slow even in the face of an inflation figure edging its way toward 2%.
In a July 30 statement, the FOMC acknowledged slow or no progress in key consumer indicators required for a full economic recovery. But the committee’s press release tried to remain buoyant, even given a lack of meaningful growth in jobs and household income, in the hope that happy days may soon be here again. The strategy in the attitude was a decidedly deliberate one, said Greg McBride, chief financial analyst for consumer finance website Bankrate.com.
“Coming into the meeting the FOMC did not want to rock the boat,” McBride said. “2014 has been a pretty good year as far as the Fed was concerned. Stock prices have spiked and the bond market is performing well. There has been some improvement in jobs as well.”
But there has not been enough improvement to change the pace of progress, which gained speed during the second quarter, but has failed to catch fire in any meaningful way, according to the analyst.
“There were no real surprises in the current statement, only subtle changes in some of the language compared to previous meeting reports,” McBride said. “I don’t think today changes anything. We’re still in a slow-growth environment. This is largely in line with what we predicted and I am reassured they have made some acknowledgment of inflation.”
When it comes to measuring inflation, the Fed looks at personal consumption expenditure index at the core level, McBride said. Currently, that rate is running at about 1.5% and it has picked up in each of the past several months. There is reason to assume progress will continue move, albeit slowly.
“A lot of investors have felt that until now the Fed has been whistling past the graveyard of inflation,” McBride said. “Today’s statement indicates that recent increases have not gone unnoticed.”
Increasing inflation means the Fed will need to accelerate the timetable on raising its rates, something for which many financial institutions have been prepared for months. Today’s meeting yielded no indication of when rates would rise, a factor perhaps best determined by the rapidity with which inflation rises. However, mid-2015 still seems to be the popular consensus, McBride says.
“If the economy continues to plod along, they won’t have upset the applecart by singing the same tune,” McBride said. “But, reassuringly, they have gotten the memo on inflation.”
The FOMC is taking deliberate steps in support of its cautious optimism. According to the press release, the FOMC will begin reducing the pace of its asset purchase program in August to $10 billion per month, down from the rate of $15 billion. The committee also will add to its holdings of longer-term Treasury securities at a pace of $15 billion per month rather than the current $20 billion per month.
In addition, the FOMC will maintain its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The committee's sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets and help to make broader financial conditions more accommodative. The pressure should promote a stronger economic recovery and help ensure that inflation, over time, progresses at a consistent rate, the press release noted.
Those efforts will no doubt be beneficial, but little meaningful progress will occur until jobs increase and household income rises significantly, McBride said. This will create an uptick in borrowing and spending necessary to have a meaningful impact on economic growth. Unfortunately this not progress the Fed can mandate.
“The Fed can’t create more jobs or higher household income,” McBride said. “They can’t create demand and for years I believe they have been pushing on a string in trying to jumpstart the economy.”
The current low interest environment of 0% to .25% also comes with its own risks, the analyst said. Without consumer demand, the Fed has little reason to amass so much liquidity and park it in reserves. Asset bubbles, such as those affecting first the dot.com industry and then the housing industry, can and do burst, leading to their own financial problems. Continued low rates are not an all-encompassing strategy, the analyst said.
“Maintaining the policy is not without its risks,” McBride said. “The Fed’s best ideas were all used up years ago and they don’t have the justification to reel in all that liquidity.”
Moreover, McBride worries that both consumers and financial institutions have been spoiled by years of low interest rates and access to “free” money. Planning for the inevitability of rising rates is something that both consumers and their financial institutions can and should have been doing.
“Consumers should pay off variable-rate loans and credit cards and refinance home equity lines of credit and adjustable rates mortgages,” McBride said. “Investors should favor short-term over long-term bonds and focus on asset quality in making their investment decisions.”
Most financial institutions have been preparing for the inevitable for months, McBride added. How consumers who are members and customers of those institutions respond is the unknown variable.
“We’re still in a slow-growth environment,” McBride said. “Be prepared and take steps now to mitigate the risk of rising rates.”