Saturday, June 28, 2014

The Fed’s Dreaded Dilemma: A Weak Economy Plus Inflation

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While the economy contracted at a greater than expected 2.9 percent in the first quarter of 2014, in May the consumer price index (CPI) rose at an annualized 2.1 percent, its highest level since October 2012. Energy prices were up 5.8 percent from a year earlier, while food prices rose 2.1 percent. Even the Federal Reserve's own preferred measure of inflation, the personal consumption expenditures (PCE) index, popped up to 1.8 percent last month.

The fact that the Fed's PCE index is showing inflationary pressure is significant, since it is essentially designed to lowball price increases. The CPI gives a 31 percent weighting to shelter costs and a 17 percent weighting to transportation (read as rent and gasoline), which the PCE basically cuts in half. By reducing the volatility of its preferred inflation gauge, the Fed essentially gives itself the leeway to maintain a looser policy longer.

But the fact that the PCE is on the rise leaves the Fed in a conundrum, having said for years now that it would act when inflation reaches an annualized 2 percent, a level that is fast approaching. The primary policy tool at its disposal for addressing inflationary pressures is interest rates, a lever the Fed probably doesn't want to press just yet. Despite the fact that inflation is clearly picking up, consumer spending has actually contracted over the past two months on an inflation-adjusted basis and is growing well below the pre-recession average of 5 percent. Incomes were also up by just 3.5 percent last month, another metric which typically ran above 5 percent for much of the two decades prior to 2008.

As we've often said in the past, the Fed has historically been slow to pull the trigger on increasing interest rates and contributed to the formation of bubbles in the economy. While some Fed officials, such as Charles Plosser, the president of the Federal Reserve Bank of Philadelphia, have said that the ba! nk should be aggressive on rates, this is the classic dreaded dilemma. It's been created by the Fed's dual mandate of working towards full employment while maintaining price stability. If it acts now to address rising inflation by raising rates, the Fed runs the risk of stalling out what has been an anemic recovery. If you lived through the 1970s, the term stagflation (a stagnant economy combined with inflation) is likely coming to mind about now, though we're nowhere near those levels yet.

Still, it should come as little surprise that the inflation debate is becoming more heated with forecasters and economists from Barclays (NYSE: BCS) to BlackRock (NYSE: BLK) sounding the alarm on the rising prices and a changing investment environment.

To break stagflation's back, famous Fed chairman Paul Volcker hiked interest rates to unprecedented levels. In 1981 the federal funds rate peaked at 20 percent and the prime rate rose to 21.5 percent. We're unlikely to see such a scenario again, but some are saying that we're likely to see rate increases by mid-2015. That, in turn, could bring the great bond run to a grinding halt as yields rise and bond prices fall. We've already seen that effect in action when the spending and inflation data was released last week, pushing the 10-year Treasury yield up to 2.625 percent and pushing gold prices up by nearly 3 percent on the day of the release.

Clearly, the time for decisive action is approaching if the Fed truly means to keep inflation tame. At this point, the deciding factor will likely be economic growth in the next half of the year; if it comes in at or above 3 percent – a reading actually well below the general consensus – look for a rate by mid-2015. Otherwise, low interest rates are likely to persist for some time yet to come, allowing inflationary pressures to continue building in the US economy.

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