Why low inflation may not prevent the Fed from reducing QE

June 19, 2013

Everybody knows U.S. unemployment, currently at 7.6%, is still too high – especially the millions of Americans struggling to find work. Less widely acknowledged is a recent dip in inflation that puts it well below the Federal Reserve’s 2 percent target. Indeed, at 0.7 percent in April, the Fed’s preferred inflation measure was less than half of the central bank’s explicitly stated goal. So why are Fed officials, gathered in Washington for their latest policy decision today, discussing a pullback in stimulus rather than an increase in it?

According to some economists, it’s because policymakers believe the recent decline in inflation will be transitory and that the rate will gradually move back up toward target as growth picks up during the rest of this year and in 2014. Yesterday’s report on consumer prices corroborated that prospect for some analysts.

Paul Ashworth, chief US economist at Capital Economics, wrote:

The low level of headline inflation largely reflects the drop back in commodity prices over the past 12 months, with even the low core rate partly explained by the indirect impact of those lower commodity prices. Under those circumstances, we wouldn’t expect the Fed to put too much weight on inflation being below its target. Once commodity prices level out, the downward pressure on consumer goods prices will begin to ease. In other words, this won’t prevent the Fed from beginning to reduce its monthly asset purchases, probably beginning in September.

Eric Green at TD Securities said:

Inflation pressures remain very subdued, but downside momentum is fading. Y/y change in core prices was unchanged at 1.7% y/y, and while this may drift down to 1.6% y/y next month that should be the low in advance of an upward drift toward 2.0% by year end. The six-month average in core prices continues to shift incrementally higher and at 1.8% puts more distance with the trough of 1.4% in December. In effect, prices are low, but the move is to the upside. It is the turn in inflation momentum rather than the level of inflation that matters on the great tapering debate. May brought more evidence that the turn is in.

Not everyone believes the decline is something Fed officials can ignore. Even within the Fed, there is some concern. St. Louis Fed President Jim Bullard said recently: “Maybe this is noise in the data, maybe this will turn around, but I’d like to see some reassurance that this is going to turn around before we start to taper our asset purchase program.”

Michael Hanson at Bank of America-Merrill Lynch says another string of low inflation readings might prompt the Fed to rethink any reduction in bond buys:

If inflation remains unusually low for much longer, the Fed will start to back away from talk of an early reduction in the pace of QE purchases, in our view. The first sign of concern would be a downward revision in the FOMC inflation forecasts.

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