The Fed’s September meeting has come and gone, and interest rates remain at zero.
The reasoning behind the Fed’s decision is sound. With emerging market economies in various states of disarray, global markets have responded by keeping energy prices low and the dollar strong. These forces have conspired to keep inflation here at home quite low. Federal Open Market Committee members’ median projection of inflation for 2015 is just 0.4%, well below it’s 2% target, which it has failed to reach for close to a decade.
Meanwhile, the Fed’s projections for what constitutes maximum employment continue to fall. In September 2014, the Fed saw unemployment in the long run going no lower than 5.2%. Well, now it’s at 5.1%, and with long-term unemployment and involuntary part-time employment so high, there’s reason to believe that the official rate has plenty of room to fall. The median FOMC member now sees the long-term rate at 4.9%.
Even though the Fed continues to miss its inflation targets and then revises down its estimates of full employment and economic growth, if you look at individual members projections, it would appear they believe that rates will still rise before the end of the year.
But why exactly is the Fed holding onto this idea? As The Wall Street Journal pointed out in August, the theory that lower unemployment will always lead to higher inflation is tenuous at best. The following chart shows the relationship between falling unemployment and inflation:
Second, the trouble abroad, which has so far filtered to the U.S. economy in the form of lower import prices and a stronger dollar, doesn’t show signs of abating. That may be one reason why market-based inflation expectations have been falling for months now:
The market doesn’t see inflation rising anytime soon, and it doesn’t agree with the median FOMC member that interest rates will go up by the end of 2015. As the the Financial Times points out, just minutes after the Fed projections were released, “Traders bet there is roughly a 49 per cent chance that the Fed moves by December, according to calculations on federal funds futures by Bloomberg.”
As Larry Summers argued earlier this week, the fact that markets don’t believe you’re going to raise rates makes it more difficult to raise rates because it sets up a situation where a move by the Fed can create economy-damaging volatility in the financial markets. The Fed has once again found itself in a position where market participants don’t believe what it is saying, and that’s a communication problem it needs to fix now.