The Fed’s Inflation Dilemma

The Fed is embarked on a program of rate hikes, namely increases in the interest rates it pays on reserve balances and on reverse repos. Its justification is what it perceives to be a strong labor market and an expected rise in inflation. The two criteria are interconnected because in the economic model it employs, a strong labor market (as indicated by employment growth and a falling unemployment rate) will eventually result in a rise in the inflation rate. Thus far, the Fed has proved to be wrong.

The Fed in effect is targeting inflation at 2 percent, as measured by the personal-consumption expenditures (PCE). But actual inflation remains stubbornly below 2 percent. It was up 1.4 percent, year over year, in June. The core rate is running at 1.5 percent. Two percent is not in sight.

Fed officials appear committed to further rate hikes, though with less conviction. Why pursue a policy when the facts do not support it?

I believe there are two possible explanations. First, officials are willing to follow the predictions of a model even when it clearly has ceased to explain the economic facts (if it ever did). Second, there other unstated reasons for raising short-term interest rates. The first explanation is likely true for some Fed officials, especially so for Chair Yellen.

The second explanation likely drives policy for other officials. There is fear that unconventional monetary policy (a prolonged period of low interest rates) has generated asset bubbles. Those officials realize the Fed is in danger of repeating policy errors that led to the dotcom bubble and bust, and the housing boom and bust. It would be impolitic to say so, however. Code language is used, such as the need to return to “normal” monetary policy.

What prognosis is there for future rate hikes? The model points to higher interest rates, and reality to no further rate hikes. I opt for the latter, at least for the rest of this year.