Inflation in the Wings?

The Federal Reserve (FRB) has been targeting a 2% inflation rate for the past few years. With the economy in rocky shape, the rate of inflation during the past several years has remained stubbornly below this target. The FRB believes that a 2% inflation rate would indicate that the economy is growing, accompanied by fewer unemployment claims and a greater number of new jobs. Recently revised government statistics indicated that the economy contracted 2.9% in the first quarter and that consumer spending was down. A Commerce Department report out today indicated that consumer spending increased 0.2% in April. After the contraction during the first quarter, consumer spending had been expected to rise by 0.4%. To put this in perspective, the inflation rate for the same period was 0.2%, which essentially means there was no real growth in spending when measured against inflation. In the 12 months ending in April, inflation advanced by 1.6%; in the 12 months ending in May it was up to 1.8%. While the annual inflation rate is still below the FRB target, it appears to be growing by about 0.2% monthly or about 2.4% annually. This would put inflation above the target.

Adding to my worry is the possibility that some of the good news in the economy could make the inflation trend even more menacing. Jobless claims for the week ending June 21st dropped by 2,000 to 312,000. Payroll gains are growing above 200,000 and are likely to be sustained. These two trends could put added pressure on inflation. So far, the FRB is saying that they will not increase the discount rate that has held at about 0% since 2009 until sometime in mid-2015.

The discount rate is the rate that is used by the FRB to control bank interest rates. The rate is lowered when the economy is doing poorly and raised when it is doing better. This rate has a direct correlation to the rate banks charge for lending. In the present circumstances, the next move to be expected by the FRB is that they will begin raising the rate to “cool down” inflation. From the time the rate is raised until it impacts the economy usually takes 3 to 6 months. If the FRB raises the discount rate too fast, it can stall the economy. If it raises it too slowly, the result could be rapidly increasing inflation. Controlling inflation is a tricky business. My thinking is, assuming inflation continues on the current path, that the FRB will have to raise the discount rate sooner than the summer of 2015.

Ed Mallon

posted Thursday, June 26, 2014 at 1:53 PM