Wednesday, August 16, 2017

An Economic Issue That the Federal Reserve Can't Fix

While the media focuses on the Federal Reserve's interest rate projections, very little attention is paid to one of the Fed's biggest problems; low inflation.  Inflation is the friend of central bankers around the world; without inflationary pressures, consumers will delay purchasing and the value of debt will grow.  

As we can see on this graph, when compared to the U.S. economy (in red), Japan's economy (in blue) has struggled for three decades with ultra-low inflation and even deflation:

This has led the Bank of Japan to massively increase its balance sheet, particularly since 2011 in an effort to kick-start Japan's economy as shown here:

In fact, as we can see from the Bank of Japan's accounts for August 10, 2017, the BoJ's balance sheet situation has continued to worsen:

According to FRED, Japan's GDP in the second quarter of 2017 was ¥545.253 trillion yen; this means that the Bank of Japan's balance sheet is now 93.4 percent of the size of Japan's entire economy!

Now, let's look at what is facing the Federal Reserve.  As we know, a key part of the Fed's two-part mandate is the maintenance of a 2 percent inflation target.  Let's look at what the market expects for inflation over the next five years, taken from the yields on five- and ten-year TIPS:

As you can see, over the past two years, future inflationary expectations have been stuck between 1.5 percent and 2.1 percent, well below the Fed's comfort zone of 2.5 percent to three percent seen during the period between 2010 and 2015.  This is particularly unusual given that the economy is at full employment, a factor that has historically led to higher inflation levels.  Even Janet Yellen has found this confusing as shown here from her testimony in July 2017:

"As I mentioned earlier, we are watching inflation very carefully.  I do believe that part of the weaknesses and inflation represents transitory factors.  Inflation has been running under our 2 percent objective.  There could be more going on there.  It is something we will watch very carefully." (my bold)

Ms. Yellen's comment suggests that the Federal Reserve is not as confident about inflation as they have led us to believe.

The forward inflationary expectations, if they come to pass, could prove to be problematic for the Federal Reserve,  particularly when the economy falls into its now overdue recession.  The next economic contraction in the United States could create that Japan-style, long-term ultra-low inflationary and even deflationary environment that central bankers dread because they simply haven't got the monetary tools to fix the problem.  Given the structural changes in the global economy thanks to demographics, it certainly looks like this will be the economic issue that the Federal Reserve can't fix.

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