The U.S. dollar is pushing higher against the euro, European stock indexes are rallying, and major U.S. stocks indexes are up nearly 1 percent on Friday following comments by Federal Reserve Chair Janet Yellen during a speech yesterday at Amhearst University that suggested inflation expectations remain well anchored and the U.S. Central Bank is likely to raise interest rates this year.
In her speech titled, “Inflation Dynamics and Monetary Policy”, Yellen compared and contrasted inflation trends over the past 50 years and concluded, “inflation is now much more stable than it used to be and it is currently running at a very low level.”
After explaining that in 2012 the Fed established a 2 inflation objective, as measured by the PCE price index, Yellen acknowledged that persistently low inflation can be “costly” and a concern for central bankers entrusted to develop effective monetary policy.
“The most important cost is that very low inflation constrains a central bank’s ability to combat recessions” Yellen admitted during her address at Amherst University in Massachusetts.
Yellen explained that during economic downturns, the U.S. Central Bank fights back by reducing the nominal federal funds rate, the rate charged by banks to lend to each other overnight at the Central Bank.
In December 2008 during the wake of the financial crisis, the U.S. Central Bank did just that and acted by lowering the federal funds rate to just above zero at .025 percent.
Since then, committee members at the central bank have given much consideration to raising interest but ultimately voted against doing so during past Fed meetings.
Yellen said that the federal funds rate and nominal interest rates cannot go much below zero because holding cash is always an alternative to investing in securities and the central bank has less room to ease monetary policy when inflation is very low.
As the U.S. economy recovers and job growth remains stable, maintaining a highly accommodative monetary policy with the federal funds appears unnecessary especially while calls grow louder for monetary policy to reset and become more normalized.
Currently, the U.S. Central Bank has been under the spotlight to raise interest rates with U.S. job growth averaging 221,000 over the past 3 months and 247, 000 over the past 12 months while the unemployment rate is at 5.1 percent and well below the 10 percent rate that occurred in October 2009.
Today in its third estimate, U.S. GDP in the 2nd quarter was revised higher to 3.9 percent from 3.7 percent, showing further proof of economic recovery.
Yellen admitted in her speech yesterday that for U.S. inflation to return back to its 2 percent target, committee members have to be “reasonably confident” that the U.S. will see continued solid economic growth and further gains in “resource utilization”, with longer-term inflation expectations remaining near their pre-recession level.
Yellen said that she and other committee members at the central bank expects labor conditions to improve further as we approach 2016 and inflation will gradually return to 2 percent over the next two or three years.
“Given that inflation has been running below the FOMC’s objective for several years now, such concerns reinforce the appropriateness of the Federal Reserve’s current monetary policy, which remains highly accommodative by historical standards and is directed toward helping return inflation to 2 percent over the medium term” Yellen said.
Falling crude oil prices and a 15 percent rise in the dollar over the past year are two important factors that are keeping inflation from moving consistently higher to the Fed’s 2 percent objective.
Although Yellen and her fellow central bankers forecast improvement in the labor market and inflation to move higher in the next 3 years, she also held out a wild card and admitted that “we cannot be certain about the pace at which the headwinds still restraining the domestic economy will continue to fade.”
Yellen said, “I expect that inflation will return to 2 percent over the next few years as the temporary factors that are currently weighing on inflation wane, provided that economic growth continues to be strong enough to complete the return to maximum employment and long-run inflation expectations remain well anchored.”
Yellen concluded by saying that she and Fed committee members “currently anticipate that achieving these conditions will likely entail an initial increase in the federal funds rate later this year, followed by a gradual pace of tightening thereafter.”
However, Yellen warned that if the economy surprises, then judgments about appropriate monetary policy will change.