What Could the Fed’s Inflation Policy Mean for the Economy?
“The Inflation Scare
Interest rates backed up last week. The 30-year T-Bond, which was 1.19% on August 4, closed at 1.44% on Friday (August 14). The 10-year T-Note closed at 0.71%. It was 0.52% on August 4. The CPI showed up with a +0.6% M/M rise (7.4% annual rate) for July. That pushed the Y/Y rate to +1.0% from +0.6% in June. Clothing prices rose +1.1% M/M in July. They had risen +1.7% in June. Airfares were up +5.4% M/M in July after having risen +2.6% in June. The U.S. money supply has grown +23% over the past year. Didn’t Milton Friedman say: “Inflation is always and everywhere a monetary phenomenon”?
The question is, “Is inflation coming back?” The answer is: “yes,” if central banks keep doing what they are doing – it’s just not coming back anytime soon, especially with the economy struggling.
The price of gold is also highly sensitive to the rate of inflation. In fact, gold is best known as an inflation hedge. The price of gold (COMEX, Dec. ’20) fell nearly 6% over the 8-day period beginning August 6 ($2,075) and ending on Friday, August 14 ($1,952). If inflation is such a huge worry, why did the price of gold suddenly fall? [The likely answer is that its price simply rose too fast ($1,708 on June 5; $1,485 on March 19) and it is now in a “consolidation” phase.]
The Fed’s Inflation Policy
For the last couple of months, as gleaned from Fed minutes, discussions are ongoing regarding a change in the Fed’s 2% inflation target. For the last decade or so, the official policy was to get inflation to 2% and stabilize it there. Thus, when 2% was achieved, the Fed would begin a monetary tightening process (negative money growth which reduces bank reserves and/or raising the Fed Funds rate, the rate banks pay for those overnight reserves) to prevent inflation from rising further. At the next set of Fed meetings (September 15-16), it appears that a policy change will be announced regarding the 2% inflation target. Instead of 2% acting as a ceiling, it is expected that the Fed will announce that the 2% inflation target is now a “long-term” average. Since inflation has been well below 2% for the last few years, it is expected that the Fed’s new policy will allow inflation to be above 2% for some period of time.
This, they will say, is not only “tolerable,” it is “desirable.” This adoption will occur because they are worried that when inflation starts to show up, the economy may still have considerable employment and production slack, and tightening prematurely may derail the expansion. [As a side note, let’s not forget about the Fed’s unwritten third objective, protection of financial markets (full employment and price stability are the written ones), as the Fed believes that the “wealth effect” plays a vital role in the health of the economy.] The conclusion here is that inflation is highly likely, just not imminent.”