Why John Williams says monetary tightening won't happen right away (Part 5 of 6)
Williams on inflation and policy
Dr. John Williams, president and CEO of the San Francisco Fed, spoke on the normalization of monetary policy and monetary tightening in a presentation to the Association of Trade & Forfaiting in the Americas in San Francisco on Thursday, May 22. The topic for the presentation was “The Economic Recovery and Monetary Policy: The Road Back to Ordinary.” In his speech, Williams mentioned that the Fed’s monetary policy would “remain highly accommodative for some time” and “a real tightening of policy—which would mean raising the fed funds rate—is still a good way off.” This part of this series will discuss the inflation considerations Williams raised that make a case for the Fed funds rate staying low.
Over the past few years, the inflation rate has remained persistently below the Fed’s 2% target, as we can see from the graph above. Low inflation is a worry because it increases the debt burden for borrowers. In a deflationary or low inflationary environment, borrowers are forced to repay loans at notionally higher values, as the money is worth more than at the time of borrowing. Businesses and consumers are reluctant to borrow and spend due to this factor, which acts as a brake on economic growth.
“The ongoing need to reduce unemployment and increase inflation both call for the same medicine: highly accommodative monetary policy. Although the goals and overall direction of monetary policy have been clear, reaching those goals has been far more challenging,” said Williams.
Inflation has trailed the Fed’s target rate primarily because of economic slack. Economic slack arises when there’s excess unused capacity in the economy—that is, when resources like the labor force aren’t used fully—or when the nation’s output is below potential. Lower import prices in 2012 and 2013 are another factor for lower prices in the U.S. The lower trend in import prices, however, is beginning to reverse, reducing downward price pressures.
Are markets expecting higher inflation? Demand for TIPS rises
Markets, however, may already be anticipating higher inflation. There was strong demand for this week’s $13 billion Treasury inflation-protected securities (or TIPS) auction. The bid-to-cover ratio came in at 2.91x, which was higher than the 2.48x recorded at the last TIPS auction in February. The non-dealer share of the $13 billion offering came in at 72%. The yield awarded was 0.339%.
Treasury inflation-protected securities (or TIPS) protect the value of debt securities from eroding due to inflation. Issued by the U.S. government, the par value of these securities increases with inflation. ETFs providing exposure to TIPS include the iShares TIP Bond ETF (TIP) and the SPDR DB International Government Inflation-Protected Bond ETF (WIP).
Which sectors perform best in inflationary times?
During times of inflation, the basic materials and natural resources sectors are two of the sectors that generally perform better, as companies in these sectors find it easier to pass on cost increases to customers. One ETF that invests in natural resources stocks is the iShares North American Natural Resources ETF (IGE). The top ten holdings in IGE include Chevron (CVX) and Anadarko Petroleum Corp. (APC). To read more about the link between inflation and the Fed funds rate, please read the Market Realist series How firms’ inflation expectations impact the Fed’s mandate.
In the next part of this series, we’ll discuss aspects of Williams’ speech regarding some of the risks that may come with rate tightening. Please read on.
Browse this series on Market Realist: