With the Federal Reserve raising interest rates once again this year, should we worry about inflation?
Over the past few months, U.S. jobs reports and economic data indicated to the Fed that it was time to raise interest rates. Just last month, the Fed did just that and raised rates for the second time this year. One metric that does not appear up to speed with the Fed is inflation.
In May 2017, inflation was 1.9%, below the 2% target. If interest rates continue to rise while inflation hovers below 2%, the American economy can be cooling down at a rate far greater than investors and economists expect. So is the current inflation rate something to lose sleep over?
Yes, and no. Inflation is a metric used by the Fed to measure the increase in prices over time, specifically by comparing current price indices values to those found last year (which among the metrics used are the PCE, personal consumption expenditure, and the better- known CPI, consumer price index).
The Fed deems that 2% is a reasonable level of inflation for maintaining its two mandates: price stability and maximum employment. If inflation runs too high, investors and everyday consumers would not be able to gauge long term financial decisions and investments.
After all, a dollar today would be worth far less only a year later. Lower inflation rates carry the risk of falling into deflation, a condition that signals lower prices, and quite possibly wages. Weak economic conditions are one factor contributing to deflation. Since inflation was 1.9%, while not particularly close to deflation territory, the risk of running lower-than-desired inflation is on the minds of Fed economists in the upcoming months. By increasing interest rates last month, the Fed makes it more expensive for corporations to borrow and purchase goods, plants, or equipment, necessities for expansion. This effectively cools down corporate purchases, and prices may not be driven up as high as it was before rate increases. The CPI and PCE track the prices on everyday goods, and as everyday items become cheaper, the CPI and PCE fall with them. The fall in CPI is attributed to a strongly weighted commodity in the index, oil.
Oil has seen a steady drop in prices over the past few months as OPEC has been unable to negotiate effective supply cuts. The Organization of Petroleum Exporting Countries (OPEC) decides on its supply of oil to the rest of the world. Restrictions on supply are a mechanism for OPEC to jack up oil prices globally, and, consequently, its profits. However, in failing to agree and abide to these supply restrictions, countries that refuse to cut down supply can profit greatly. Crude oil hovers around $45, down over 10% from its YTD peak. As oil prices decrease, its weighting within the CPI and PCE suppress inflation metrics. So the current inflation of 1.9% seems largely seasonal, and should bounce back as OPEC continues to negotiate supply cuts and prices rise over the midterm.
While recent jobs reports show slower new job growth than in recent years, it is not so daunting as to alarm economists. If the American economy continues to reduce unemployment, and refrain from ever posting another March 2017 jobs report in the upcoming months, the risk of dangerously low levels of inflation are minimal. The recent suppressed inflation is more seasonal than anything else, as the CPI and PCE hold falling oil prices into account for price comparisons. Should the American economy slow down, either indicated through upcoming jobs reports and economic data, inflation would surely represent that. The Fed has brightened its outlook on the American economy in recent weeks but will closely look at inflation levels to gauge their decision in another rate hike later this year.