Great Inflation

Inflation risks and inflation expectations

U.S. inflation has been low and steady for three decades. This welcome stability is not merely a consequence of good fortune. Shocks that in the past might led to higher trend inflation—like the energy price increases—continue to buffet the economy much as they did in the 1970s and 1980s, when inflation rose to a peacetime record. Rather, it reflects the improved monetary policy of the Federal Reserve, which began acting as an inflation-targeting central bank in the mid-1980s, long before it announced a 2% target for inflation in 2012. As a consequence of the Fed’s sustained efforts, long-run inflation expectations have remained close to 2% for more than 20 years. One result is that temporary disturbances that drive inflation above or below target quickly fade.

This is the optimistic conclusion of the 2017 U.S. Monetary Policy Forum (USMPF) report. Since the adoption of the de facto inflation-targeting regime, one-off shocks have little impact on the inflation trend. Moreover, as many have observed, the relationship between unemployment and inflation—the Phillips curve (see our primer)—is now notably weaker. However, the authors of that earlier report warn that the Phillips curve “flattening” could be a direct consequence of the Fed’s success. Furthermore, since the sample period from 1984 to 2016 excludes any sustained period of a very tight economywide labor market, it would not be possible to detect an outsized impact, if any, of persistently low unemployment on inflation.

Enter the 2019 USMPF report, which focuses on the possibility that inflation may indeed respond differently when the unemployment rate is very low and projected to remain low for several years (see, for example the FOMC’s latest Summary of Economic Projections). The logic is straightforward: if labor is very scarce for an extended period, employers will bid up wages and (unless they are prepared to accept declining profits) pass on those cost increases in the form of higher prices….

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Inflation Policy

Inflation in the United States remains at levels that most people don’t really notice. Overall, the consumer price index rose 2.8 percent from May 2017 to May 2018. And, when you look at core measures, the trend is still below 2 percent.

With inflation and inflation expectations still so benign, it is no wonder that despite solid economic growth and the lowest unemployment rate in 50 years the Federal Open Market Committee continues to act quite gradually (see their June 2018 statement). Inflation could well turn up in the near term—perhaps by more than the policymakers expect. But, for reasons that we will explain, if we were on the FOMC, we would stay the planned course: remain vigilant, but certainly not panic.

We start with a look at the data. What we see is that trend inflation has stayed reasonably close to the Fed’s medium-term target of 2 percent for the past two decades. There have been occasional deviations, like the temporary rise in 2008 and again in 2011, but overall, the path is remarkably stable….

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