Saturday, January 18, 2014

The Fed – A House Divided

US inflation continues to fall and the Federal Reserve remains divided. The core consumer price index (CPI) rose by a meagre 0.11% (on-month) in December, the least amount in eight months. On-year inflation in core prices remained at 1.7%,
where it’s been for the past nine months but with increases falling on the margin, the on-year rate will soon drift lower too. Core personal consumption expenditure inflation – the Fed’s favoured gauge – has fallen to 1.1% on-year with the headline version of that measure running at 0.9%. Inflation is low and getting lower.
The Fed remains divided on what to do about it. Plainly, it has begun to taper its bond purchases and some officials have made it clear they want that to continue absent outright calamity. Others are calling publicly for the Fed to do more to support growth and raise inflation, the latter of which they feel is too low and presents risks of its own to the outlook. A return to greater bond purchases – dialling quantitative easing back up, that is – would be a welcome move, in their view. Some of the differences are over what to do about the Fed’s huge store of reserves.
Most of that QE1, QE2 and QE3 – some $3.2 trillion of balance sheet expansion now – never went into the economy, which is why growth and inflation never took off. Eighty-five percent of it went straight into the vaults in the Fed’s basement in the form of excess reserves held by the banks the Fed bought its bonds from. All that money the Fed “injected into the economy” never went into the economy. It never went into the stock market. It never came rushing over to Asia.
But the hawkish camp at the Fed is worried that someday it will and that’s one of the reasons they want to wind down QE3 now. The banks are free to take that money and put it into the economy anytime they wish. At some point they will. Growth will start to accelerate. Unemployment will start to fall for the right reasons (people becoming employed) and not for the wrong reason (people dropping out of the labour force; 885,000 workers have done so over the past six months alone). And inflation will start to go up. Someday.
The dovish camp at the Fed thinks that day will be a good one – one to cheer, not to fret over. They would like to hasten its arrival. Instead of raising rates paid on reserves to make banks want to leave them at the Fed, the dovish group wants to cut the rate paid on reserves (perhaps all the way into negative territory) so banks will do precisely the opposite: get that money out of the Fed’s house and into the economy.
Pretty clear differences. Pretty strong convictions. Where does Yellen stand on this? No one knows. She’s been quiet as a mouse since her testimony before Congress back in November. She was quiet as a mouse in the three months leading up to it too. Yellen takes over February 1. Perhaps she’ll say something then.

For now, the Fed’s is a divided house.