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Tame inflation shows Yellen's Fed is not 'behind the curve'

Michael Santoli
Michael Santoli

Never mind all the overheated talk that Janet Yellen’s Federal Reserve is slipping “behind the curve” in containing inflation. Today’s cool consumer-price reading and the collective wisdom of the bond market are suggesting the Fed is amply ahead of that curve.

One month’s consumer price index can’t tell the whole story of inflation risk, of course. But with June’s headline CPI arriving as forecast at 0.3% - and the core measure (excluding food and energy) registering below expectations at 0.1% - Yellen’s patience in projecting interest-rate increases, and her characterization of an uptick in inflation gauges early this year as “noisy,” are ratified.

Fed officials characterized the recent pickup in inflation as confirming their projections after nearly two years of weaker-than-forecasted aggregate price growth,” Bank of America Merrill Lynch economist Michael Hanson notes. After today’s data release, he adds: “The Fed is likely to remain patient in the face of the current modest inflationary trends, and not make a hawkish rush to the exit.”

This is the kind of low-key observation that gets the conspiracy theorist, policy-skeptic contingent exercised. They like first to scoff at the idea of excluding the bump in gas prices from the inflation debate, as if it “doesn’t matter." (And the "pain at the pump" angle did drive some headlines following the release Tuesday morning.)

Gas prices matter to ordinary people in everyday life, sure. But the fact is, rising prices in commodity-based necessities act more as a drag on broad consumption than a driver of widespread cost increases. As this chart shows, periods with wide gaps between headline and core inflation do not tend to precede a general lift in inflation.


Next, the policy dissenters insist the large amounts of bank reserves created by the Fed’s prolonged bond-buying efforts are sure to create some kind of messy inflationary outbreak. But it hasn’t happened yet and shows no real signs of occurring, aside from supporting some unknowable proportion of the ascent in risk-asset prices over the past few years.

There is a fair, good-faith debate occurring about wage inflation, typically the key to any inflation cycle, and its recent climb above 2%. Deutsche Bank economist Torsten Slok has been vocal in warning of upward momentum in wages.


Yet this comes after such a long stretch of stagnating incomes that it is viewed by Yellen and others as a belated and welcome move in the right direction, rather than an imminent risk to stable prices.

Beyond all this talk – which, like any overabundant resource, is very cheap – the bond market is silently making its own opinion pretty clear. The yield on the two-year note has been jerked up and down lately as expectations build and ebb for the anticipated date of the first rate hike. But the weighty verdict of long-term Treasuries is that inflation is not a lasting problem.

The 30-year Treasury yield, having come down from 3.92% to 3.28% so far this year, is not begging for tighter monetary policy at all. Some are arguing exactly the opposite, in fact – that the rally in long-duration bonds represents the market’s invitation for easier money in light of weak inflationary pressures and risks to the growth outlook.

There are global forces weighing on long-term yields, of course, including dramatically lower government yields in nearly every other developed economy. Even as the Fed has been reducing its monthly bond buying on the way to likely ending it in coming months, the effect hasn’t really reduced liquidity because the shrinking U.S. deficit has similarly cut monthly Treasury issuance.

At minimum, though, it’s important to heed the possibility that - even with job growth remaining healthy and wages picking up - there is no insistent market demand for Yellen to alter her wait-and-see approach to determining when the economy is ready for non-zero short-term rates.

This is one reason Yellen has resisted the idea of cinching up rates just to box the ears of risk-taking investors in the junk-bond and speculative-stock arenas, preferring to verbally cite risks of market excesses and point to regulatory tools for reining in lending aggression.

She doesn’t want overconfident investors to become the reason the Fed is pressured to shift policy in a direction the economy might not be quite ready for – and she shouldn’t.