Over the last year, Federal Reserve officials have dramatically curtailed ambitions for interest-rate increases, even as inflation has risen and unemployment has declined.
So what gives?
Perhaps just as important as the increased attention being paid to headwinds from abroad are the changing attitudes of Fed policy makers toward inflation. That suggests more confidence they can afford to keep borrowing costs lower for longer, because there is less concern that price pressures will get out of hand.
Conventional wisdom says actual inflation trends depend largely on inflation expectations, and to a lesser degree, the amount of slack in the economy. The significance of the latter has been called into question as economic slack has been used up.
As Fed Chair Janet Yellen put it during a June 6 speech, a stronger labor market would typically be expected to push inflation higher. “But such estimates are inherently imprecise, and the effect on inflation could turn out to be significantly different, either upward or downward, than I expect,” she said.
Central bankers are also coming to terms with the fact that they don’t really understand what they believe to be the more important determinant of inflation -- expectations -- very well either.
Take a recent study by Fed economist Jeremy Nalewaik, who found that while inflation expectations and actual inflation were closely connected prior to the mid-1990s, the relationship has deteriorated markedly since then.
“Movements in inflation expectations now appear inconsequential since they no longer have any predictive content for subsequent inflation realizations,” Nalewaik wrote.
He cites as a potential explanation for this a hypothesis offered in a 2000 paper co-authored by Yellen’s husband, Nobel prize-winner George Akerlof, who wrote that “when inflation is low, it may be at most a marginal factor in wage and price decisions, and decision-makers may ignore it entirely.”
Akerlof’s and Nalewaik’s research jibe nicely with ideas that St. Louis Fed President James Bullard has injected into the debate on the rate-setting Federal Open Market Committee this year.
Bullard stopped submitting longer-run economic forecasts when the latest round of policy makers’ projections was compiled in mid-June, stating in a June 30 speech that “the timing of a switch to an alternative regime is viewed as not forecastable, and so we simply forecast that the current regime will persist.”
Nalewaik suggests that a return to a world in which inflation expectations and actual inflation become more tightly linked, as they were before the mid-1990s, may not be in the cards.
“Model estimates show it would take PCE price inflation above 3.3 percent or CPI inflation above 4.0 percent for several years to produce a transition back into the high-variance, high-persistence inflation regime,“ he said, referring to the personal consumption expenditures price index and the consumer price index.
This helps explain why the “risk-management approach” to monetary policy in the current environment -- a phrase now in use by influential policy makers like Fed Governor Lael Brainard, New York Fed President William Dudley and Chicago Fed President Charles Evans -- is spreading among officials. They simply see very little risk that inflation will surge out of control.
Evans has taken the risk-management argument, which dictates that the Fed can be slow to raise interest rates because of increasing uncertainty about global growth amid an environment of muted inflation, a step further.
He argued in an Aug. 3 briefing with reporters that the FOMC should consider engineering an intentional overshoot of the Fed’s 2 percent inflation target -- which their preferred measure of inflation has been undershooting for the last four years -- to make sure they can stabilize it around that level in a sustainable way.
The Chicago Fed chief also questioned a fundamental notion that has governed the actions of central bankers since Milton Friedman famously quipped in 1960 that monetary policy works with long and variable lags. The implication of Friedman’s observation is that the Fed must begin raising rates before inflation gets to its target.
“That was very much a 1970s phenomenon, where inflation expectations continued to increase as policy didn’t meet reasonable inflation goals,” Evans said. “I think we should be careful in wondering how many things that we learned from previous periods are still really front and center, and still truly active.”
Still, not everyone on the FOMC is convinced.
“I’m definitely not one of those who thinks we should wait until we see inflation get to 2 percent before we raise rates,” San Francisco Fed President John Williams said in a Washington Post interview published Thursday. “I think that would put us significantly behind the curve.”
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