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Inflation Plays a Significant Role in Monetary Policy Measures

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The Fed’s inflation target and the effects of energy price slowdown

The Fed’s inflation target for the economy is 2%, which is barely achievable, as October data showed a 0.12% inflation rate. The slowdown in energy prices has reduced the growth of inflation, as energy constitutes an important portion of consumer spending. Exploration and production companies spend a lot in new capacity development.

For most US energy companies like ExxonMobil (XOM), Chevron (CVX), and Hess (HES), capital expenditure growth has fallen 2%, 6%, and 8%, respectively on a year-over-year basis. The Energy Select Sector SPDR ETF (XLE) and the United States Oil Fund (USO) are down 16% and 50%, respectively, over the past year. Many exploration and production companies operating in Texas have recently laid off some employees. This cyclical effect has also contributed to lower consumer spending, resulting in lower inflation numbers. The graph below shows US inflation and the Fed funds rate.

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Interest rate

The Fed’s meeting is scheduled for December 15-16. The probability of a rate hike in December has grown after the FOMC’s (Federal Open Market Committee) meeting on October 28. This time, the probability of a rate hike grew to an all-time high because the Fed is expecting the economy is now able to justify an initial rate hike after a decade. Moreover, this time the question is about Fed credibility to control the world market.

Since 2008 after the subprime crisis, the Fed has kept interest rates near zero. The logic behind the step is to provide cheaper capital for the development of businesses. But in recent times, the Fed is struggling with problems that are out of its scope:

ECB’s stance on interest rate

The European Central Bank (or ECB) is also maintaining a target of 2% inflation. But according to the current scenario, the Eurozone’s inflation is in the negative zone of -0.1%. To achieve the inflation target and stimulate economic activity in the region, ECB’s president, Mario Draghi, said it may provide further easing to achieve the target. He also added that if the current steps aren’t enough to achieve the inflation goals, then the ECB will do what’s necessary to raise the inflation rate as soon as possible.

Investors are now eagerly waiting for the upcoming meeting as the world’s two largest central banks are heading in opposite monetary policy directions.

For more, read Bill Gross: The US Economy Needs a Steeper Yield Curve.

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