How long does “temporary” or “transitory” last?

Yellen has made her position (shared by others at the FOMC) clear:

First, she is somewhat puzzled by the inflation data. Second, that bewilderment will not deter them from keeping to their established “hike path”.

Interestingly, two years ago she delivered a speech, which was all about inflation, in fact setting the foundation for beginning the “tightening” cycle, the first move of which took place three months later, in December, and was almost immediately temporarily “aborted” (remember Stan Fischer´s “4 rate hikes for 2016?)

Highlights from the speech: “Inflation Dynamics and Monetary Policy

Policy Implications
Assuming that my reading of the data is correct and long-run inflation expectations are in fact anchored near their pre-recession levels, what implications does the preceding description of inflation dynamics have for the inflation outlook and for monetary policy?

This framework suggests, first, that much of the recent shortfall of inflation from our 2 percent objective is attributable to special factors whose effects are likely to prove transitory.

… Although an accounting exercise like this one is always imprecise and will depend on the specific model that is used, I think its basic message–that the current near-zero rate of inflation can mostly be attributed to the temporary effects of falling prices for energy and non-energy imports–is quite plausible. If so, the 12-month change in total PCE prices is likely to rebound to 1-1/2 percent or higher in 2016, barring a further substantial drop in crude oil prices and provided that the dollar does not appreciate noticeably further.

… Given the highly uncertain nature of the outlook, one might ask: Why not hold off raising the federal funds rate until the economy has reached full employment and inflation is actually back at 2 percent? The difficulty with this strategy is that monetary policy affects real activity and inflation with a substantial lag.

If the FOMC were to delay the start of the policy normalization process for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession.

Note that back then, she was emphasizing the “transitory” nature of the below target inflation. Two important elements behind the “temporariness” of low inflation: the fall in oil prices and the dollar appreciation.

The chart shows what transpired following her speech. Oil prices increased significantly (before falling again more recently) and the dollar didn´t move much until early this year when it began a downtrend (depreciation).

In her speech, Yellen notes that:

Models used to describe and predict inflation commonly distinguish between changes in food and energy prices–which enter into total inflation–and movements in the prices of other goods and services–that is, core inflation. This decomposition is useful because food and energy prices can be extremely volatile, with fluctuations that often depend on factors that are beyond the influence of monetary policy, such as technological or political developments (in the case of energy prices) or weather or disease (in the case of food prices). As a result, core inflation usually provides a better indicator than total inflation of where total inflation is headed in the medium term.

Yes, she should stick to looking at core inflation. As the chart suggests, significant moves in oil prices may have a secondary and small impact on core inflation.

In any case, now that her preferred temporary factors (oil & dollar) are, at least the dollar, pulling inflation in the “up” direction and inflation “insists” on moving “down”, Yellen appeals to new “temporary” and “transitory” factors. That´s the role now played by such things as the drop in prices of cellphone connections and drug prices.

Since there will always be prices that fall, the “transitory” nature of low inflation will persist indefinitely!

Bottom line: The FOMC is dumb enough to continue on the “hiking path”!


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