Brendalee Scott-Novak, Butterfield

 Addressing the National Association for Business Economics (NABE), Federal Reserve Chairman Janet Yellen delivered a striking tone on the inflationary debate. Reiterating the “mystery” surrounding the recent low inflation readings, the chairman’s candid remarks did very little to stir markets.

Openly admitting the failure of monetary policy to spur inflation is one thing, but citing the committee’s possible misreadings behind the shortfall is profound for such a renowned institution sporting the brightest minds. How could these overtures not send markets into a tailspin? Could it be the case that investors need time to digest the news, or have markets long resorted to looking beyond the rhetoric to muddle through the inflation maze?

The answer lies somewhere in the fact that the inflation debate is a challenging and uncertain game. One needs to look no further than Japan’s struggle over the last two decades, or more recently, the actions of the European Central Bank and Bank of England having very little success in spurring inflation. Why then is the inflation target so elusive for policymakers?

Following the credit crisis, global central banks undertook some very unconventional policies to keep their respective economies afloat. Chief among the Federal Open Market Committee’s (FOMC) actions was the introduction of a zero interest policy. Since changes in economic activity and inflation occur with some lag subsequent to interest rate moves, central banks can only implement policies based on their potential versus actual impacts on the economy. In 2009, as the U.S. economy demonstrated signs of a recovery, the committee sought to reverse its accommodative stance with an eye towards fighting expected inflation.

Over the last nine years, Personal Consumption Expenditures (PCE), the Fed’s preferred gauge for inflation, has consistently failed to breach its 2 percent medium-range target set in 2012. Core inflation, which strips out food and energy prices, has also been running well below that level.

While the unemployment rate is firmly anchored at 4.4 percent, well below pre-crisis levels, further improvement in the labor market is expected to put upward pressure on wages. Other idiosyncratic forces that have restrained inflation recently are also expected to fall away. While the combination of these factors has historically been strong enough to push inflation higher, the chairman has cited a few factors that could derail the inflation goal and keep rates lower for longer.

Long-run inflation expectations

It is no surprise that markets and policymakers alike have both missed the mark in forecasting actual inflation. In the latest FOMC forecasts, there is still a 30 percent probability that the inflation rate will be either greater than 3 percent or below 1 percent due to oil prices, changing value of the dollar and other esoteric factors. Crucial to the effectiveness of the Fed as a policymaking body is its ability to shape expectations based on its influence in the past and guidance on the future. If long-run inflation expectations continue to diverge from the actual inflation rate, it could undermine the committee’s credibility and lead to instability in the real economy. Consequently, missing the inflation rate then becomes a real possibility.

Strength of the labor market

The rate of unemployment consistent with the economy operating at maximum capacity, commonly called the natural rate of unemployment, cannot be estimated with statistical precision. Due to structural and demographic changes in the real economy, this actual sustainable rate can shift over time and read much lower than historic projections.

It is, therefore, quite plausible that one of the reasons for the current shortfall is that the natural rate of unemployment is below the Fed’s median forecast of 4.5 percent. The implication that there may be much more slack in labor markets than previously anticipated partially explains the lack of wage growth and inflationary pressure. A further corollary would be that the economy could accommodate even higher levels of employment, necessitating a change in monetary policy to compensate for the lower inflationary expectation.

Dynamics driving inflation

Perhaps the most significant factor raised by the chairman is the possibility that the committee misspecified fundamental drivers of inflation. Given the changing global dynamics, there is increasing probability that other inflationary forces that have not been present historically are missing from the committee’s econometric models. An example is the falling cost of healthcare, a historically large component of household spending. Others have pointed to the integration of global labor supply and ease of accessing those markets, which reduces wage pressure on the local economy. Still there are other arguments touting technological disruptors, such as online behemoth Amazon providing cost-effective alternatives, thus keeping prices subdued.

Regardless of the reasons for the shortfall in inflation, missing the target rate over an extended period cannot be ignored. A persistently low inflation rate generally equates to a lower benchmark rate in normal times. While this may be cause for celebration for debtors, the general health of the economy would be at risk. Having benchmark rates close to zero limits the ability of policymakers to act in the event of adverse shocks to the economy and undermines the Fed’s credibility. The good news is, however, that the committee believes the recent inflation readings are merely temporary. If they are not, the committee stands ready to adjust their views and chart whatever course necessary to maintain their dual policy mandate. 

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