5 reasons Fed chair may let inflation rise this year: Don Pittis

Despite an announcement this week that U.S. core inflation ischarging above two per cent,Federal Reserve chair Janet Yellenisn't raising interest rates. In fact, yesterday's statement by the U.S. central bankpredictsrates will only rise half a percentage point this year, much lessthan they've suggested in the past.

• U.S. Federal Reserve keeps benchmark interest rate steady
• Inflation in Canada rises to 2% on higher food and gas prices

Asked directly at yesterday's news conference whether the bank was willing to let inflation climb,Yellensaid,"We are not trying to engineer an overshoot for inflation." Nonetheless there are some good reasons why Americans, and by extension Canadians, might expectprices to rise faster than theyhave recently.

1. Fed uses different stats

While the U.S. consumer price indexreleased this week showed core inflation at 2.3 per cent,that is not the measure the Fed uses to make itsinterestrate decisions. For complicated reasonsthe Fed uses something called personal consumption expenditures or PCE.

Besides being generally lower than CPI according to the Wall Street Journal, the Fed's measure includes prices hidden from normal consumers such as money paid from insurers to hospitals that never passes through the consumers' hands. That means the prices that consumers actually feel can climb much higher before the Fed steps in.

2. Rising oil

While it doesn't use CPI,the Fed still uses the"core" version PCE which is around 1.7 per cent. Core refers to the price rises you actually experience with a difference. Statisticians strip outenergy and other goods considered volatile. While a handy statistical tool for the Fed, it creates some complications depending on whether oil prices are rising or falling.

While oil prices were falling, stripping them out of core inflation madeconsumers feelprices were falling faster than the measure used by the Fed to tell it to lower interestrates. As oil prices rise, consumers feel their expenses rising sharply. But becauseoil is stripped out of core PCE, this measuretellsthe Fed to wait longer before raising rates.

3. Fear of falling

In spite of her commitmentnot to let inflation overshoot, several other comments from the Fed chair were more equivocal even if they were buried in denser language. At one point she admitted to "caution in removing policy accommodation." (My translation: "reluctanceto raise rates.")

The reason was that if trouble develops, brought on by difficulties in China or Europe for example,it is hard to cut rates from current lows, but relativelyeasy to raise them should inflation turn up.In Yellen'swords, "Monetary policy has greater scope to respond to upside than to downside changes in the outlook."

4. Labour catch-up

While prices have been creeping up and unemployment has been falling, inequality is still growing, something Yellennoted.Usually inflation consists of both prices and wages, but as Yellen said, "Wage growth has yet to show a sustained pickup."

Those who favour higher inflationinsistit is one way to help wages rise. While saying employment gains could be hurt by "some significant overshoot" in inflation if the Fed left rates too low, Yellen seemed to leave open the chance of an overshoot, so long as it was not "significant."

The fact is, the Fed is not forced into an all-or-nothing stance to prepare itself to battlelong-terminflation. Yellen can continue to raise rates butat a pace slow enough to hold price increases to just slightly above the current inflation target. However, that issomething the Fed chair might not want to say too distinctlyfor fear of propelling inflation expectations higher.

5. Election year

Askedabout one member of the Federal Reserve who had donated to a presidential political campaign, Yellen strongly asserted the Fed's complete lack of political bias.

However, in his book Money, Banking and the Economy, Barry Siegelpoints to the many times central bankers have refrained from raising rates as much as they might haveduring an election year. "Not to berate monetary authorities for bending to political pressure," he writes, "merely to acknowledgethat no government institution can avoid them."

Such influence would be less likely during a lame-duck presidency. And there is a way toput a better complexion on such an occurrenceshould it happen. As an appointed official, ifthe Fed chair felt that raising or cutting rates at a critical moment in a campaign would lead to charges of playing politics, it would be just as wise to wait a month or two before taking policy action.

Inaction during a campaign is so much less politically charged than being seen to interfere.

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