Key takeaways from Yellen’s speech: Solving the inflation problem
Janet Yellen's speech hints on what the Fed dashboard looks like (Part 4 of 9)
Why deflation is dangerous
Janet Yellen spoke on monetary policy and forward guidance at The Economic Club of New York on Wednesday, April 16. In the last part, we discussed the labor market indicators likely to shape the Fed’s future monetary policy. In this part, we will discuss the second of Janet Yellen’s “three broad questions”: Is inflation moving back toward 2%? The answers to this and the other two questions posed by the Fed Chair are likely to shape future monetary policy.
One of the Fed’s most important goals is ensuring price stability. In a numeric sense, the Fed has defined price stability as ensuring that the long-term rate of inflation stays at about the 2% p.a. level. This is because very low levels of inflation or deflation pose a serious hazard to economic growth as they point to lack of demand in the economy, which depresses prices. The Fed uses the change in personal consumption expenditure (or PCE) as reflective of inflation in the economy.
Janet Yellen on the deflation hazard
According to Yellen, deflation is detrimental to both businesses and households: businesses are impacted because deflation increases real interest rates, dis-incentivizing them from capital formation and increasing output and creating jobs, which is counter-productive to the Fed’s monetary stimulus efforts to induce economic recovery. Further, when interest rates increase, this increases the debt burden for households and borrowers alike, which impacts consumption.
The inflation vs. deflation debate: Unexpected outcomes can result from unprecedented stimulus levels
The Fed hopes that reducing the slack in the labor market would lower the inflation drag. As more employment is generated, this would boost consumption and demand, which should boost inflation. However, the impact of labor market slack on inflation remains to be seen as the labor market tightens, as the impact of higher slack has not lowered inflation enough, although very high levels of labor market slack persisted in the recovery.
Further, the Fed still expects its baseline case of 2% inflation to be well-anchored. However, due to the unprecedented stimulus over the past few years, the Fed must continually assess inflationary trends in the economy. Indeed, inflation may substantially cross 2%. However, according to Yellen, “at present, I rate the chances of this happening as significantly below the chances of inflation persisting below 2 percent, but we must always be prepared to respond to such unexpected outcomes.”
For the views of the other Fed officials on inflation and labor market slack, read the Market Realist series, Why Fisher says Fed asset purchases are still too substantial.
All else equal, in an inflationary environment, equity investments in the basic materials and commodity sectors generally tend to perform well. ETFs in the commodity space include the iShares North American Natural Resources ETF (IGE), which tracks the S&P North American Natural Resources Sector Index. Top holdings in the IGE include Chevron (CVX) and Anardarko Petroleum Corporation (APC). Fixed income ETFs offering protection against inflation include the iShares TIPS Bond ETF (TIP) and the SPDR Barclays Capital TIPS ETF (IPE).
Read the next part for a discussion on factors that, according to Janet Yellen, may derail the recovery.
Browse this series on Market Realist:
