The US Federal Open Market Committee (FOMC) lowered the target Fed funds rate—by a quarter of a percentage point to 2%—further below the inflation rate on 30 April. In suggesting that inflation will “moderate in coming quarters, reflecting a projected levelling out of energy and other commodity prices”, the committee appears to be assuming a Phillips Curve relationship, whereby slow or negative growth and consequential higher unemployment will produce lower inflation.
The 1970s, however, demonstrated that the Phillips Curve relationship between unemployment and inflation is weak, and can be overwhelmed by rapid money growth and soaring commodity prices. It is thus very possible that, within months, rising inflation will force the Fed to reverse course and raise interest rates.
The Fed’s expectation that energy and commodity prices will level out certainly isn’t coming true yet. Since it began cutting rates in September, the oil price has increased 39% and the Reuters CRB Index of commodity prices has risen 24%. Those substantial increases have yet to feed fully into domestic US prices. When that happens, reported consumer prices may soar as producer prices have already done. With wages already subdued, the inflation-suppressing Phillips Curve effect could be insufficient to counteract this. Money supply, which on a broad basis has been increasing more rapidly than nominal gross domestic product since 1995, has also soared this year.
The St. Louis Fed’s MZM (money of zero maturity, an approximate equivalent of total money supply referred as M3) measure of broad money is up an annualized 30.3% in the three months to April. Increases in money supply work with a lag so this exceptionally rapid increase has yet to feed through into consumer prices. In lowering interest rates further, the Fed may have exacerbated the problem.
If so, then at some point even official US consumer price inflation figures, which arguably understate reality, will rise far enough that the Fed will have to address the inflation problem. To do so, it will have to raise interest rates until they are significantly above the inflation rate. That process, like the current downturn, won’t be pleasant.
The Federal Open Market Committee lowered the target Fed funds rate by 0.25% at its Wednesday meeting, where governors Richard Fisher and Charles Plosser voted against the cut. The advance estimate of first quarter US gross domestic product announced on 30 April showed an increase of an annualized 0.6%, the same as in the fourth quarter of 2007.
Meanwhile, the price index for domestic purchases increased at 3.5%, compared with 3.7% in the fourth quarter. The March consumer price index was up 4.0% on the previous year, while the finished goods producer price index was up 6.9% and the crude goods index up 31.4%.