The Federal Reserve took no action at its September 2015 meeting, leaving the federal funds rate about as low it can go at 0% to .25%. The Fed cited uncertainty over international economic conditions and low inflation in the US for why they again postponed beginning the “normalization process” of raising interest rates. The decision to leave rates unchanged was disappointing for some and a relief to others. The Fed’s Zero Interest Rate Policy (known as “ZIRP” by Fed watchers) has now been in place since December of 2008 and the last interest rate increase was over 9 years ago (June 2006).
The Federal Reserve has a dual mandate of maintaining full employment and stable prices. The most recent unemployment reading was 5.1%, the lowest level in seven years and near the fed’s long term target of about 5%. The latest annualized overall inflation rate was 0.2%, with consumer prices (CPI) actually slipping slightly into negative territory at -0.1%. The Fed officially targets a 2% annual inflation rate as the measure of price stability. (see chart below)
Higher interest rates are used by the Fed as a tool for slowing down an overheated economy or stemming high inflation. Clearly we have neither of those situations in play right now.
Most of us remember Fed Chairman Paul Volker’s use of high interest rates to gain a heroic victory over the runaway inflation of the 80s. The prevailing force at present is disinflationary, meaning a sustained decrease in the rate of inflation. If the rate of inflation drops below zero, it becomes deflation.
Many economists fear deflation even more than inflation. Consumers anticipating lower prices may delay their purchases. This behavior curbs economic growth and adds deflationary pressures, creating a self-reinforcing cycle, one Japan has experienced for the last 20 plus years.
To be clear, the right kind of deflation can be a good thing. Technological advances have made cell phones almost universally affordable. A USB memory stick today is more powerful than the computers that put a man on the moon. The wrong type of deflation, however, can be ruinous. Falling real wages in Greece are a good example. This kind of deflation occurs during periods of low or negative economic growth, such as we saw recently during the Great Recession” of 2008/9. Remember the effect on housing prices?
Deflation is especially dangerous in economies where debt is high and economic activity is sluggish. Inflation helps debtors because future dollars are worth less and so they pay back with “cheaper” dollars. In deflationary periods the opposite occurs. Debts become more expensive in real terms.
Deflationary forces are at work around the world. Low wages in developing economies, enhanced productivity via technology, disruptive new business models (Uber, Airbnb), demographics (older people buy less), cheap energy from enhanced production and falling cost for renewables, are all exerting downward pressure on prices. We may well be beginning a sustained period where the prevailing winds are deflationary rather than inflationary, something virtually nobody alive today has ever experienced firsthand for the American economy. The uncertainty over whether the Fed or anyone else has the tools to respond in such an economic environment may explain much of the market’s recent turmoil.
