Changes may be afoot at the Federal Open Market Committee, which meets every six weeks, to assess the health of the U.S. economy. For years
now, Chair Janet Yellen has emphasized that the Fed is “data-driven” in how it makes decisions about interest rates. One of the main data points the Fed watches is the rate of inflation, which is defined as an increase in overall prices; 2% annual inflation is the target rate the Fed has adopted as its goal. The Fed has the ability to change short-term interest rates up or down or keep them steady, depending on how the U.S. economy is growing or not. Low interest rates help an economy that is struggling, and high interest rates rein in an economy that is overheating.
One of the Fed’s mandates is price stability, and the way to achieve this is to produce price changes that are not too fast and not too slow. In the data-driven model, the Fed has been waiting for inflation to reach 2% and hold steady. U.S. inflation was above 2% earlier this year, but now it has drifted lower. Instead of waiting for inflation to stabilize at 2% or above, the Fed is now poised to raise its benchmark interest rate for the third time this year in mid-December whether or not inflation reaches the 2% target. This is a significant change from the data-driven model. Dr. Yellen now believes that the U.S. economy is strong enough to deal with gradually rising interest rates and that inflation will catch up as the economy strengthens and interest rates return to normal levels.
Problem: Low Inflation
In response to the 2008 financial crisis, the Fed dropped its benchmark interest rate to zero in order to stabilize the economy by encouraging borrowing and risk-taking. Now that the economy has been growing slowly and steadily since 2009 and the labor market is tightening, it is time to gradually raise interest rates, reduce the stimulus, and allow the economy to stand on its own. The problem with low inflation is that it keeps interest rates low and limits the Fed’s ability to respond to economic downturns as it did in 2008. At the beginning of the financial crisis in 2007/2008 the Fed Funds Rate was at 4.25%, which gave the Fed plenty of room to cut rates and stimulate the economy. With this benchmark rate now at 1.25%, there is little room to respond effectively to a crisis.
With a tightening labor market, low unemployment figures, and increasing wages, inflation should be on the rise. The mystery of low inflation has stimulated a far-ranging debate among Fed officials. Some believe that the low inflation is a sign that the economy is weaker than it appears. This is the minority interpretation. Dr. Yellen and her closest allies believe this low inflation is an aberration. Other economists including Dr. Martin Feldstein at Harvard believe that it really does not matter whether inflation is 1.6% or 2.0%. In the late 1970s, Dr. Feldstein experienced 10% inflation. His position now is that inflation at 2% or lower is just fine.
Household Net Worth
On September 22, the Wall Street Journal reported that due to the rising stock market and rising home prices, U.S. household net worth had reached an all-time high. Overall household wealth has risen for seven quarters in a row, and household debt is the lowest it has been since 2000. These healthy household balance sheets indicate that the economic expansion beginning in 2009 and the rising stock market may be far from over. I believe that one of the benefits of a slow and steady recovery is that it can last a long time, and outlast a dramatic boom —much like the tortoise and the hare. The economic strength of U.S. households is very important because 70% of the U.S. economy depends on consumer spending.
Janet Yellen is signaling that the Fed is ready to adapt its target inflation rate strategy by gradually increasing interest rates even though inflation is below its target of 2%. This is a vote of confidence in the economy and the continuing expansion. With steady job growth starting in 2009, a tight labor market, increasing wages, high household net worth, and widespread growth among the world’s largest 45 economies, this is a time to continue the benefits of your long-term investment strategy. I applaud the Fed’s willingness to adapt strategies in response to measurable dissonance. Let your animal spirits run!