Why U.S. Interest Rates Are Rising So Sharply Even Though Inflation Is Non-Existent

As we all know, the Federal Reserve has two mandates: keep the inflation rate low (officially, they have an optimal rate of two percent) and try to keep employment at or near maximum levels. 

Because the extent of the recession has been so large and deep, in both of these measures, the Federal Reserve has not yet attained either goal. As a result, the Federal Reserve has enacted an extremely aggressive monetary policy stance. 

While the unemployment rate has continued to come down, partly because of the drop in the participation rate, at least the economy is creating a decent level of jobs. Over the past six months, the average monthly increase in jobs has been 163,000, which amounts to just under two million new jobs per year. 

The inflation rate, however, is going in the opposite direction. One of the biggest worries for the Federal Reserve is a situation of deflation—deflation is far worse and more difficult to fix than an inflation rate that is too high. 

The recent data for the Consumer Price Index (CPI) reported an increase of 0.1% in May and a 1.4% increase year-over-year. (Source: Bureau of Labor Statistics web site, June 18, 2013, last accessed June 19, 2013.) 

The core CPI rate was up slightly higher at 1.7% year-over-year, due to both food and energy seeing a drop in price over the past 12 months. This is not a surprise, as large companies such as Wal-Mart Stores, Inc. (NYSE/WMT) reported dropping prices for groceries. 

The drop in the inflation rate is a surprise to everyone, including the Federal Reserve. It had expected to begin seeing the inflation rate start rising to its target of two percent, yet the opposite is occurring. 

As I mentioned, the inflation rate will increase only when the velocity of money starts to increase, the latter being closely tied to the level of transactional activity in the economy. However, because the employment situation is so tenuous, people are feeling anxious and uncertain, which makes them less inclined to aggressively spend, leading to businesses holding back on capital expenditures and job creation. That drop in expenditures and job creation then leads to a lack of wage pressure, which is important when calculating the inflation rate as all of these factors are tied together. 

While the Federal Reserve has done as much as it can to try and stimulate the economy, for the inflation rate to begin rising, we would need to see wages move up, which would then lead to increased demand for goods, leading to business expansion. 

The chart for the 10-Year U.S. Treasury Yield Index is featured below:

Chart courtesy of www.StockCharts.com 

You might ask: if the inflation rate is so low, why are interest rates moving up? The answer is that this is a reaction to the possibility that the Federal Reserve will reduce its level of asset purchases. If you knew that the biggest buyer in a market was about to stop purchasing more assets, your natural reaction would probably be to sell ahead of this buyer. 

The Federal Reserve will begin to reduce its asset purchase program later this year, in my assessment, even if the inflation rate remains so low. This reduction will happen for two reasons: the first being a limited amount of supply available for purchase, and the second being the Federal Reserve needs to move away from policies that are born in a crisis scenario. Obviously, we are far from the depths of the recession, but we are still not at normal economic levels. 

The real question is: can the Federal Reserve adjust its monetary policy to prevent the inflation rate from moving substantially higher from the Fed’s target level? 

Even though the inflation rate is low now, it could move up relatively quickly. History has shown that the Federal Reserve has been slow to adjust monetary policy. What we do know is that the trend will be for a reduced level of monetary stimulus over the next few years. The issue is whether the reduced level will be in time to prevent the inflation rate from rising. We will have to keep watching the data to see if pricing pressures begin to build.

 ~ by Sasha Cekerevac, BA 

This article Why U.S. Interest Rates Are Rising So Sharply Even Though Inflation Is Non-Existent was originally published at Investment Contrarians