Monetary policy

Fed worries about deflation, not inflation

Outside common wisdom in the context of massive monetary easing, the Fed worries about deflation, not inflation, at least for now, according to the policy statement from the latest FOMC meeting that ended on July 31. “The committee recognizes that inflation persistently below its 2 percent objective could pose risks to the economic performance,” the Fed policy statement said, “but it anticipates that inflation will come back toward its objective over medium term.”

A week ago, there was an article on the Wall Street Journal predicting that the Fed might move to impose a low bound of 1.5 percent for inflation. The Fed has already adopted an upper bound of 2.5 percent for inflation early this year. This strategy by the Fed essentially mimics what the Bank of Canada has been doing for over ten years. I predicted the Fed would follow a range target for inflation in my note on Jan. 10 this year.

The Fed recognized the difficulties of transmitting the monetary policy into the real economy. The high unemployment put a lot of pressure on wage increases and the wage suppression is a major contributor to the low inflation. Now that some unemployment has become structural, it will take longer time to reduce the unemployment rate.

The Fed is very keen to bring in the government to help reduce unemployment if fiscal stimulus can be introduced. However the government in the U. S. seems to be in no rush to do so.

Additional accommodative monetary policy is becoming less and less effective in driving down the long term interest rates. The yield of the U. S. ten year bond is now standing at 2.7 percent, more than 1 percentage higher than a month ago. The Fed might be left no choice but to wind down the bond buying program starting early next year (my prediction). Meanwhile the Fed will pray and beg for a good inflation number.

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