MNI INSIGHT: Fed Sees Inflation As Too Low, But Unpredictable

Internal research casting doubt on the idea that full employment would tend to push inflation over 2% contributed to the Federal Reserve's recent shift to average inflation targeting, but policy makers are also increasingly conscious of the shortfalls in their knowledge of price dynamics and recognize that surges in inflation could take them by surprise, MNI understands.

The link between low unemployment and higher inflation has become increasingly fragile in recent years, even though the relationship between labor slack and wage growth doesn't appear to have shifted. Policymakers now think unemployment can move much lower than in the past without stoking higher prices.

Inflation surprisingly failed to spark years into the pre-Covid recovery in spite of historically low unemployment. Even more puzzling to the Fed was that underlying inflation turns out to have been largely unresponsive to changes in economic conditions for the past quarter century, converging to as low as several tenths below 2% in models after slack and economic shocks are stripped out.

This implies that even should the economy grow steadily and unemployment fall to 4%, inflation would likely not reach 2% over the long run, let alone surge past it in any 1970s-style double-digit redux.

COMPETING THEORIES

That might suggest a change in firms' pricing behavior in the digital era, an argument made by the leaders of the Dallas and Richmond Fed banks, among others. Online competition has made retailers more reluctant to raise prices while globalization has restrained input costs.

Another theory is that inflation expectations have simply become better anchored, thanks to former Fed Chairman Paul Volcker's 1979 promise and eventual success at reining in prices whatever the cost.

But while the trends are coincident, there is no conclusive evidence of causation. Economists do not understand how expectations are formed and enter the inflation process.

For now, policymakers want to change the perception that 2% is a ceiling rather than a longer-run target and for investors to become comfortable with the notion that the Fed won't react aggressively to above-2% inflation.

But the Fed is also reluctant to rule out a scenario in which a so-called kinked Phillips Curve could cause inflation to rise at a steeper rate past a certain point. For example, a fall in unemployment to 3.6% from 4.1% could prompt an acceleration in prices while an earlier reduction of equivalent magnitude from 4.1% from 4.6% might have had little effect. Joblessness could also tumble so rapidly that bottlenecks pump inflation higher.

So, while a surge in inflation looks unlikely now, even Fed officials admit it's not impossible. High inflation and low unemployment would be a very bad outcome for the Fed, which has said it will keep rates at zero until both maximum employment is reached and inflation is on track to moderately exceed 2%.

It won't react to surprise inflation if it is short-lived, but if its trajectory is unexpectedly steep, officials may well invoke one of the escape clauses included in its new targeting arrangements to reassess.