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Fed Policymakers Divided Over Late-Cycle Weak Inflation

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Federal Reserve Board members can’t identify the reasons behind the weak inflation, albeit other macro fundamentals suggest the pace of price growth is supposed to be quicker, and above the targeted 2 percent.

Kristian Rouz — Underperforming US inflation against the backdrop of sustainable economic growth and a solid labor market is a "mystery", according to the Federal Reserve's Chairwoman Janet Yellen. Some central bankers admit the below 2 percent target price growth might be a lasting phenomenon, and it could stick around in the long-term, as the current US business cycle is nearing its end.

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Some, however, argue the inflation could gain momentum based on the low unemployment figures, but the stagnant wages and low labor productivity are hardly encouraging in this regard. Yellen herself called the US fiscal authorities to implement measures addressing low productivity.

The division on the Fed policy board could eventually derail the central bank's tightening cycle, putting the projected December hike in interest rates into question. Higher borrowing costs put additional downward pressure on price growth, unless other factors, such as national currency FX rate, are taken into account.

"We are all trying to get a grip on it," Dallas Fed President Robert Kaplan said.

The Federal Reserve is expecting unemployment to fall further, down to 4.1 percent amidst the White House's crackdown on illegal immigration, but inflation will still be below the 2 percent target, according to Kaplan's projections.

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He speculated that either technology or the patterns of international trade are allowing consumers to save on their purchases. Indeed, the "overvalued" — according to President Trump's definition — US dollar renders US imports cheaper, whilst technology, such as e-commerce, prevents retailers from hiking prices: it is always cheaper, albeit a less satisfying shopping experience, online.

Kansas City Fed President Esther George says the underperforming inflation — at 1.4 percent in recent weeks — is not reason enough for the Fed to back off their planned interest rate hikes.

"It is hard for me to see…any of that is related to weak economic activity," George said, adding that low unemployment and solid consumer sentiment, as well as retail readings, would have pushed inflation higher under normal circumstances.

There is a certain "brake" that hinders inflation, Fed policymakers admit, and the Trump administration's proposed fiscal package in the form of tax cuts and greater budget spending might spur inflation by heating up consumers.

However, the "mysterious" reasons behind weak price growth might offset the market effects of the fiscal stimulus as well.

The current Fed board does not really have to worry much about inflation, as in early 2018, a new team of policymakers is set to commence work, and inflation is going to be their number one concern. The new team's approach is expected to be drastically different than that of Yellen's.

"Most of the names being considered would offer little continuity with Yellen's approach," Michael Feroli of New York-based JP Morgan Chase & Co said. "For many of them, inflation theories may take precedence over the inflation data."

The Federal Reserve, on the other hand, has to continue increasing borrowing costs amidst the unprecedented expansion on the stock market. Bubble concerns are hardly easier than the worries of low inflation and overpriced assets in the housing market is a yet another issue.

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Some point out, in the current environment of globalization in the consumer market, inflation will inevitably be weak despite low unemployment. Wages, however, will also suffer, as labor costs are contained by the lack of customs tariffs in many countries. Subsequently, global free trade equals workers across the globe grinding out a living in poverty rather than affluence.

"The combination of the growing contestability of markets and prolonged synchronized weak demand may be restraining wage expectations," Bank of England Governor Mark Carney said. "Technological changes, particularly those which could globalize markets for many services, may extend and deepen the trend of global disinflation."

The new Fed leadership will thus have to deal with a greater uncertainty amidst the robust macroeconomic figures and develop their policy path in the environment where most existing monetary theories are not any longer applicable.

Unless President Trump and the Treasury quickly impose the border tax and devalue the dollar, which will inevitably unwind the inflationary spiral.

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