It’s like a cold case that still baffles investigators. After years of rock-bottom interest rates and with unemployment at 3.8 percent, where is the inflation? It’s a whodunit that hangs heavily over the Federal Reserve.
Not only is it clouding the central bank’s monetary policy decisions, it begs questions about how policy makers should pursue their mandate for maximum employment and stable prices. That’s a big reason why the Fed has just kicked off a year-long review of how best to achieve those goals.
“It’s almost surely true that inflation is less tightly linked to what’s going on in the real economy than it used to be, and that matters a lot,” said Jeffrey Fuhrer, director of research at the Boston Fed.
The Mystery
Since the Fed set 2 percent as its explicit inflation target in January 2012, its favorite gauge of prices has averaged just 1.4 percent. Exclude volatile food and energy prices, and it noses up to 1.6 percent.
To be fair, unemployment was high for some of those years, but even in the months since March 2017 when joblessness fell below 4.5 percent, core inflation has averaged 1.7 percent. Moreover, the puzzle pre-dates the recession. Going back to 1993, that gauge has averaged 1.8 percent.
So What?
Is this really such a bad thing? For those who remember the 1970s and ’80s, inflation a few ticks below the Fed’s objective seems like a good problem to have. Still, low inflation can be troublesome.
Along with lukewarm rates of economic growth, below-target inflation is keeping interest rates historically low. That makes it harder for the Fed to fight recessions because there’s less room to cut rates before hitting zero.
Low inflation can also corrode a central bank’s most important asset: credibility. It’s widely accepted that public faith in the Fed’s commitment to hitting 2 percent can help meet that goal. Missing persistently to one side risks undermining that confidence.