Federal Reserve Chairwoman Janet Yellen on Tuesday defended the central bank’s projection for a gradual path of rate increases over the next few years despite the past few months of unexpectedly low inflation.
She said, however, the Fed could slow the pace of rate increases if low inflation persists and officials conclude it reflects long-term changes in the economy rather than transitory factors.
Ms. Yellen and her colleagues have been grappling with subdued inflation despite a growing economy and vigorous labor market. That has presented officials with a dilemma. From one point of view, the weak inflation readings could be a sign that interest rates should remain lower than anticipated. Yet keeping interest rates low for too long could cause inflation to grow too rapidly and inflate new financial bubbles.
Inflation, under the Fed’s preferred measure, has undershot the central bank’s 2% target for much of the past five years. Although Ms. Yellen said she expects inflation to gradually move up to the target, she acknowledged the uncertainty surrounding that prediction. The Fed has raised rates four times since 2015 and has penciled in one more rate increase this year.
“How should policy be formulated in the face of such significant uncertainties? In my view, it strengthens the case for a gradual pace of adjustments,” Ms. Yellen told a National Association for Business Economics conference in Cleveland. “It would be imprudent to keep monetary policy on hold until inflation is back to 2 percent.”
Ms. Yellen’s speech boosted market expectations of a rate increase at the Fed’s December meeting. Investors pegged a 77.9% chance of a rate move Tuesday afternoon, up from 72.8% a day ago, according to CME Group data.
How to respond to weak price growth has been a burning topic among Fed officials. Some, such as New York Fed President William Dudley, argue that the strong economy will soon push up inflation, suggesting a need to continue raising interest rates.
“I expect inflation will rise and stabilize around [the Fed’s] 2% objective over the medium term,” he said Monday. “In response, the Federal Reserve will likely continue to remove monetary policy accommodation gradually.”
Others, such as Charles Evans of the Chicago Fed, see no indication that inflation is about to turn higher.
Speaking in Michigan on Monday, Mr. Evans said he believed weaker inflation reflected structural changes in the economy rather than a temporary phenomenon.
“I think we need to see clear signs of building wage and price pressures before taking the next step in removing accommodation,” he said.
In her talk, Ms. Yellen sought to strike a middle-of-the-road approach, one that weighed the risks of raising rates too slowly against the risks of raising rates too fast before concluding that the Fed should stick to its current cautious course.
Moving too quickly could slow growth unnecessarily, she said, but added that “we should be wary of raising rates too gradually.” Moving too slowly could create “an inflationary problem down the road that might be difficult to overcome without triggering a recession,” she said.
Still, the Fed’s understanding of inflation is “imperfect,” she said, calling the shortfall in inflation “a mystery.” “We recognize that something more persistent may be responsible for the current undershooting.”
In a presentation filled with footnotes and slides, Ms. Yellen summarized academic research on inflation’s recent behavior. It could be, she said, that the labor market still has a way to go before it has fully healed from the recession. Or inflation expectations, which affect actual inflation, might have weakened. Those conditions, she said, could “result in a policy path that is somewhat easier than that now anticipated.”
It could also be that something has fundamentally changed in the economy, either globally or in the U.S., that would hold down price growth, she said.
For instance, spending on health care, which represents 8% of consumer expenditures, could be slowing in part because of the 2010 health-care law, she said. U.S. inflation also could be more closely tied to the global economy, which means weakness abroad or cheaper labor costs in other countries could be holding down domestic prices and wages. Ms. Yellen also cited the possibility that online shopping could be holding down inflation.
Although the Fed chief didn’t say she believes one of these factors is behind recent slow price growth, she said officials would keep a close eye on developments.
“We will monitor incoming data closely and stand ready to modify our views based on what we learn,” she said.
Source: Dow Jones