Frog's-Eye View

The Mystery of Missing Inflation Weighs on Fed Rate Move (Original article)
by Josh Zumbrun -- Wall Street Journal
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U.S. near full employment, but inflation hasn’t risen as predicted; Fed officials can’t figure out why 

Fed Chair Janet Yellen, in a speech at the University of Massachusetts Amherst in September, 
acknowledged ‘significant uncertainty’ about her prediction that inflation would rise. 
PHOTO: SCOTT EISEN/BLOOMBERG NEWS

Federal Reserve officials this week are expected to raise interest rates for the first time in nine years on the expectation that employment and inflation will hit targets reflecting a healthy U.S. economy.

But Fed officials face a troubling question: Jobs are on track, but inflation isn’t behaving as predicted and they don’t know why. Unemployment has fallen to 5%, a figure close to estimates of full employment, while inflation remains stuck at less than 1%, well below the Fed’s 2% target.

Central bank officials predict inflation will approach their target in 2016. The trouble is they have made the same prediction for the past four years. If the Fed is again fooled, it may find it raised rates too soon, risking recession.

Low inflation—and low prices—sound beneficial but can stall growth in wages and profits. Debts are harder to pay off without inflation shrinking their burden. For central banks, when inflation is very low, so are interest rates, leaving little room to cut rates to spur the economy during downturns.

The Fed’s poor record of predicting inflation has set off debate within the central bank over the economic models used by central bank officials. Fed Chairwoman Janet Yellen, in a 31-page September speech on the subject, acknowledged “significant uncertainty” about her prediction that inflation would rise. Conventional models, she said, have become “a subject of controversy.”

Ms. Yellen faces dissent from Fed officials who want to keep interest rates near zero until there is concrete evidence of inflation rising, voices likely to try to put a drag on future rate increases.

While the job market is near normal, “I am far less confident about reaching our inflation goal within a reasonable time frame,” Charles Evans, president of the Chicago Fed, said in a speech this month. “Inflation has been too low for too long.”

For a generation, economists believed central banks had control over the rate of inflation and could use it as a policy guide: If inflation was too low, then lower interest rates could boost the economy; high inflation could be checked by raising rates.

Inflation’s about-face

Today’s conundrum over low inflation marks a turnabout. Former Fed Chairman Paul Volcker tamed persistently high double-digit inflation in the 1980s, after a decade of stagflation—a period of rising prices, slow growth and high unemployment that confounded economists. For years afterward, central banks adopted slow and steady inflation growth targets of 2%.

The Fed’s preferred measure of inflation rose an average of 2.038% a year between 1992 and 2007, bolstering confidence that economists understood how inflation worked. The price of a Fourth of July barbecue, for example, closely tracked the 2% annual target over that period: Average prices for a pound of ground beef went to $2.70 from $1.91; American cheese climbed to $3.91 a pound from $3.01; a 16-oz bag of potato chips rose to $3.65 from $2.84. Wages also rose modestly so workers kept pace.

Central bankers “thought that it must be their own doing,” said Jon Faust, the director of the Center for Financial Economics at Johns Hopkins University, who served two stints at the Fed during that period. “We thought we figured out macro policy, and we could deliver low, stable inflation and stable output and low unemployment and all things good.”

The financial crisis deflated that confidence. Confronted by low inflation and sluggish economic growth, the U.S. and U.K. nearly seven years ago—and the eurozone three years later—slashed interest rates to near zero.

Central banks also created money and used it to buy bonds, hoping to push down their yields, thereby encouraging households and businesses to borrow or plow their money into higher-risk projects. The Fed pumped $2.5 trillion of reserves into the banking system.

The Bank of Japan launched the biggest program of all, buying assets three years ago that took its balance sheet from 25% to 75% of the country’s annual output. Officials pledged to raise inflation to 2% within two years.

While the world’s major developed economies continue to grow, inflation rates have fallen short: The eurozone has annual inflation rate of 0.1% and 1.9% growth in output from a year ago; the U.K has minus 0.1% inflation and growth of 2.3% over the same period; Japan, 0.3% inflation and 1.1% growth; and the U.S., 0.2% inflation and 2.2% growth.

Low oil prices have helped tamp down inflation. But measures of core inflation, which exclude volatile food and energy prices, have also run below the Fed’s target for more than three years. It is currently 1.3%,

“There’s no way in hell anybody reasonably predicted, using the mainstream models, that you would end up with inflation this low,” said Adam Posen, the president of the Peterson Institute for International Economics, a think tank with an international focus.

“Macroeconomics is in the era of Kepler and Copernicus and Tycho Brahe. We built Ptolemaic models and thought we were doing quantum mechanics,” said Mr. Posen, who served on the Bank of England’s monetary policy committee from 2009 to 2012 and pressed his central bank colleagues at home and around the world to launch more aggressive monetary action to revive stagnant economies and boost inflation rates.

Mr. Posen was on the winning side of those debates—major central banks doubled down on stimulus efforts—but expected inflation never materialized.

Former Fed Chairman Ben Bernanke, in an interview, pointed to Congress as one culprit for inflation’s weak performance. As Fed chairman, he urged Congress in the aftermath of the recession to temporarily boost government spending and focus on longer-run measures to control debt. By raising demand, that spending would also boost inflation. After an $830 billion stimulus plan in 2009, however, Congress turned to shorter-run budget cutting.

Mr. Bernanke said in an interview that a central bank’s ability to raise inflation would have to assume “at least reasonably cooperative” fiscal policy. In other words, the central bank can only do so much to stabilize the U.S. economy if lawmakers are working against Fed efforts.

A new theory about low inflation has emerged from former Bank of Japan governor Masaaki Shirakawa. While his former professor, University of Chicago economist Milton Friedman, said inflation could only be caused by a surge in the money supply, Mr. Shirakawa raised demographics as a cause.

Japan’s aging population during the 1990s and 2000s seemed to unleash powerful deflationary forces, according to his theory, by lowering expectations of growth, straining the government’s budget and putting a growing proportion of Japanese consumption in the hands of older people who draw on savings rather than younger wage earners.

The population of Japanese ages 15 to 64 has fallen from around 87 million in the mid-1990s to about 77 million in 2015, according to data from the Organization for Economic Cooperation and Development. That means fewer working-age people to buy existing homes or purchase products, putting a damper on the economy’s ability to boost demand or bid up prices.

In a prescient 2012 speech, Mr. Shirakawa said the U.S. and Europe would face similar conditions: “I cannot entirely rule out the looming menace that may unveil itself into downward pressure on inflation rates.”

In 2014, a trio of economists at the International Monetary Fund endorsed many of Mr. Shirakawa’s hypotheses, arguing there are “substantial deflationary pressures from aging” and that “this applies not just to Japan, but also to other countries with aging or declining populations.”

Debate over inflation and its causes has come to a boil in recent months, with other theories joining Mr. Shirakawa’s ideas about aging countries and Mr. Bernanke’s blame of stingy fiscal policy.

Economists challenged Fed officials about their understanding of inflation during two days of talks this summer at the Kansas City Fed’s annual monetary conference in Jackson Hole, Wyoming,

Mr. Faust of Johns Hopkins University said the long-standing view that central banks could control inflation was a myth. “There’s very little support for the view that inflation is simple and we had it figured out,” he said.

Ms. Yellen spent more than two months working on her September inflation speech, studying over an August vacation at her Berkeley, Calif. home.

In September, she said that low inflation was the result of weakness in the labor market, which would soon end, as well as a sharp decline in oil prices and the dollar’s rise. As oil and the dollar stabilize. and slack in the economy diminishes, she said, inflation should start rising toward the 2% target.

Ms. Yellen’s theory relies on long-held notions of a trade-off between inflation and slack in the economy—the gap between output and economic capacity—as well as links between wages and inflation. This thinking is based on research conducted by the researcher A.W. Phillips.

Using British data, Mr. Phillips in the late 1950s found that when unemployment was high, wages tended to be low; conversely, wages rose as unemployment fell. This historic relationship, known as the Phillips curve, hasn’t functioned as well of late. The jobless rate has fallen from 10% in 2009 to 5% in October, but inflation also has fallen.

A Phillips curveball

Ms. Yellen said in her September speech that the relationship has frayed in recent years. Some of her Fed colleagues are more skeptical.

“A variety of econometric estimates would suggest that the classic Phillips curve influence of resource utilization on inflation is, at best, very weak at the moment,” said Lael Brainard, a Fed governor who works down the hall from Ms. Yellen.

The global economy may be undermining the Phillips curve, according to Robert Steven Kaplan in his first speech as Dallas Fed president last month. That view is echoed by researchers who say competition from China and other low-wage economies depresses U.S. wages.

A Wall Street Journal survey of economists in August found two-thirds of them still believe there is link between lower unemployment and higher inflation.

But the relationship is affected by outside factors. Criticisms of the Phillips Curve model, and its precision, increasingly come from economists on all sides of the spectrum. So far, economists haven’t coalesced around a superior explanation of inflation’s behavior.

Fed officials are coming around to the idea that inflation is influenced by the thinking of families, investors and business owners. Price movements, up or down, can become a self-fulfilling prophesy, according to economists.

When businesses and workers expect high inflation, they try to command higher prices and wages, respectively, helping push up inflation. When they expect prices and wages to fall, they slow spending, which would help push down inflation.

Since the 2007-2009 financial crisis, inflation expectations have sunk. “I talk to a wide range of business contacts, and virtually none of them are mentioning rising inflationary or cost pressures,” Mr. Evans said. “No one is planning for higher inflation. My contacts just don’t expect it.”