Ten years into the recovery and with unemployment near half-century lows, the Federal Reserve’s traditional models suggest inflation should be surging. Instead, officials are grappling with unexpectedly tepid price growth, prompting some to rethink their strategy for steering the US economy.
Minutes to the Fed’s latest meeting revealed a discussion about the slow-inflation conundrum and concern over the public’s falling expectations for inflation. Worryingly for the Fed, a University of Michigan survey in February showed households expected the lowest inflation in half a century over the coming five years.
The persistent shortfalls relative to the Fed’s 2 per cent target have already helped prompt officials to shelve prior plans for further rate rises. But Fed officials are also thinking more broadly about the bank’s inflation mandate — a topic that will be up for discussion at a major Fed conference in June.
Some analysts see the Fed embarking on a revised approach in which policymakers sometimes deliberately aim for above-target inflation.
“The world is not operating by the old rules,” said Diane Swonk, chief economist at Grant Thornton. “Inflation is simply not responding to low unemployment, strong growth and faster wage rises. In the short term this means the Fed has stepped to the sidelines on interest rates and the balance sheet. In the longer term they will rethink their inflation target, and you are starting to see them build up the case for doing this.”
When former Fed chair Janet Yellen embarked on monetary tightening in 2015 her approach was rooted in economic orthodoxy. This dictates that a hotter labour market will stoke both wage and price growth. Late into 2018, the Fed’s leadership was still worrying about the risks of economic overheating.
Fed officials’ faith in the so-called Phillips Curve linking unemployment and inflation is being shaken by persistently tepid price data, however. Having peaked at 10 per cent after the crisis, unemployment is now just 4 per cent. Wage growth has picked up to over 3 per cent, but the measure of core inflation favoured by the Fed remained below 2 per cent in November, as it has done for all but six months of the past decade.
Jay Powell, the Fed chair, highlighted overseas and domestic threats to growth when he adopted his “patient” stance on rate rises in January. But some Fed policymakers are putting US inflation data front and centre in their decision-making. Several said in the Fed’s January rates meeting that they would only agree to further rate increases if inflation numbers exceed their expectations.
Tepid inflation will feature in discussions over the Fed’s longer-term approach to steering the economy at a conference in Chicago in June. The conference, which Richard Clarida, Fed vice-chairman, is due to preview in a speech on Friday in New York, will look at strategies, tools and communication policies the Fed uses to pursue maximum employment and price stability.
The discussions will raise questions about how policymakers should cope with a world where the neutral interest rate — where monetary policy neither boosts the economy nor holds it back — remains relatively low, forcing them to repeatedly slash rates to near-zero levels. Officials worry that inflation expectations could sink given the limits to the Fed’s ability to boost prices with stimulative policy.
One option would be for the Fed to simply target a higher inflation rate, which could give it more ammunition to cut rates in a downturn. However, that would trigger a political firestorm in Congress and is unlikely to be adopted.
Numerous alternatives exist, among them so-called price level targeting, where the Fed commits to keep the level of prices rising along a steady path. This approach ensures the central bank promises to make up for past periods of excessively low or high inflation, but is complicated to explain to the public.
A similar option discussed by officials including John Williams, the New York Fed chief, and his predecessor Bill Dudley, would be to seek to meet the inflation target on average over a period of years. This would mean that when inflation has been below target for a while, the Fed would aim for a period of above-target inflation.
At the Chicago conference attendees will also discuss the tools the Fed can deploy after rates are slashed, among them asset purchases like those used during the financial crisis, and negative interest rates, which have been deployed by other central banks.
Further debate will centre on central bank communications. Among the more vexed areas is the so-called dot plot of policymakers’ interest rate expectations. The latest minutes revealed some officials have been fretting that the public see the median dot as a formal policy forecast from the Fed, which it is not intended to be.
Ditching the dot plot entirely would be contentious, though, given the Fed’s declared commitment to transparency about its policies.
Michael Feroli, US economist at JPMorgan Chase, said he believed changes were already afoot in the Fed before the Chicago conference convenes. He sees signs that the central bank is moving in a direction where it seeks to achieve the inflation target on average over a business cycle. “We believe the Fed’s inflation objective is subtly but profoundly evolving,” he said in a recent note.