The Fed and the Factors Conspiring Against Its Inflation Target

Wednesday saw the release of the minutes from the July meeting of the Federal Reserve’s Federal Open Market Committee — the group that determines interest rate policy. The report showed officials believe they are inching closer to the point when their zero interest rate policy will end.

However, some were concerned at the time that incoming data had yet to instill “reasonable confidence” that inflation would return to the FOMC’s 2 percent target over the medium term.

Fed officials have made their outlook for inflation a key determinant of when they will choose to raise interest rates, and have declared that they will not act unless confident that inflation appears to be inching back up towards their target.

Three years ago the Fed declared 2 percent annual inflation to be the rate that they view as consistent with the price stability mandate Congress bestowed on the central bank in 1977. However, the Fed has failed to hit its inflation target, as a perfect storm of factors conspire to maintain downward pressure on prices for consumers.

Annual Changes In Overall CPI

Wednesday morning the Bureau of Labor Statistics reported July consumer inflation data, showing the Consumer Price Index was a mere 0.2% compared to a year ago, and up 1.8% if food and energy prices are excluded. Prices are being held down by low energy costs and still-slow economic growth.

Two Main Factors Preventing Higher Inflation:

1. Strong Dollar

The U.S. dollar has rallied 20 percent against major currencies since the second half of 2014. The FOMC minutes noted that:

“Some participants also discussed the risk that a possible divergence in interest rates in the United States and abroad might lead to further appreciation of the dollar, extending the downward pressure on commodity prices…”

2. Low Energy Prices

The concerns about China’s growth has also led to a drop in oil prices, with investors concerned that the world’s largest oil consumer will have a reduced thirst for crude. Fed officials touched on this topic, the minutes said, worrying about:

“… risks of further declines in oil and commodity prices, and the possibility of further appreciation in the dollar.”
Source: U.S. Energy Information Administration

So slower economic growth in China, in the face of an oil supply glut, combined with a stronger U.S. dollar suggest that the trend of subdued inflation is likely to continue.

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