Incoming Fed chief faces challenge to boost US inflation to above 2pc

Incoming Fed chief faces challenge to boost inflation to above 2 per cent while keeping interest rates at zero amid a tapering of bond purchases

PUBLISHED : Tuesday, 28 January, 2014, 1:35am
UPDATED : Tuesday, 28 January, 2014, 3:50am

One of Janet Yellen's first challenges as Federal Reserve chairwoman is generating enough inflation to meet the US central bank's target of 2 per cent.

Policymakers have failed to attain their goal for almost two years and now are paring the pace of their bond purchases. Inflation rose at a 0.9 per cent rate for the 12 months to November, according to the Fed's preferred measure. The last time prices were climbing at or above 2 per cent was in April 2012.

"Every month that passes with inflation stuck below the target, the pressure to come up with a plan to deal with it grows," said Ethan Harris, co-head of global economics research at Bank of America in New York. "They are slowly acknowledging that this is a serious risk."

Eric Rosengren, president of the Federal Reserve Bank of Boston, said earlier this month that too low inflation could be "a cause for real concern" because it increased the possibility that a "negative shock" to the economy might lead to deflation.

Persistently low inflation can theoretically undermine the credibility of the central bank

That could cause households to delay purchases in anticipation of even lower prices and companies to postpone investment and hiring as demand for their products dried up. Too low inflation also meant higher inflation-adjusted interest rates, making it harder to achieve a sufficient pace of growth.

"Furthermore, persistently low inflation can theoretically undermine the credibility of the central bank," said Rosengren, who dissented against the Fed's December decision to cut monthly bond purchases by US$10 billion. If the Fed announced a goal "but is unable to achieve that target in a reasonable time frame, some may call into question its ability to do so in the medium or long term as well", he said.

Officials justified their December 18 decision to reduce monthly asset purchases to US$75 billion by citing improvement in the job market, convincing investors the taper did not constitute a tightening of policy by also extending the timeline for zero interest rates.

Yellen, who won Senate approval this month to succeed Ben Bernanke as chairman from Saturday, would need to reinforce that rate commitment to ward off the threat of disinflation, said Harris, a former New York Fed researcher.

"She's going to have to step up and pretty clearly clarify to the markets [how she's] going to deal with low inflation," he said. "It slows down the whole exit, both in terms of the speed of tapering and timing of the first rate [increase]."

The Federal Open Market Committee, which starts a two-day meeting today, said last month that it "recognises that inflation persistently below its 2 per cent objective could pose risks to economic performance, and it is monitoring inflation developments carefully".

The FOMC decided to cut the pace of bond purchases "in light of the cumulative progress towards maximum employment and the improvement in the outlook for labour market conditions", the committee's December 18 statement said.

The unemployment rate in the United States dropped to 6.7 per cent in December, the lowest since October 2008. The decline has come partly because of discouraged workers leaving the labour force.

While the Fed had made "significant progress", there was still "this question about inflation", Bernanke said last month. "We take that very seriously."

Inflation had been slower than expected because education costs might not be rising as quickly as in the past, and prices of goods such as new cars and apparel "are quite benign because, frankly, the economy hasn't been that strong", said Stephen Stanley, chief economist at Pierpont Securities in Connecticut.

While US gross domestic product rose at a 4.1 per cent annual pace in the third quarter of last year, growth was 1.1 per cent and 2.5 per cent in the first and second quarters.

Yellen might get "a pass for a while" on criticism of too low inflation because she inherited it; still, "missing by 1 per cent year after year is a problem", said Stanley, a former Richmond Fed researcher. "They're probably going to be patient at 1 per cent, but if it were to start moving down further, that would be the point at which they'd start to worry," he said.

Fed officials cut their forecast for inflation in December as they raised their assessment of the labour market. They said prices, measured by the personal consumption expenditures price index, would rise 1.4 per cent to 1.6 per cent this year, compared with September's 1.3 per cent to 1.8 per cent, according to their central tendency estimates, which eliminate the three highest and three lowest projections.

None predicted the Fed would achieve its 2 per cent goal this year.