Why is inflation undershooting the Fed’s 2 percent target?
During the Great Recession of 2008-09, the rate of inflation fell sharply, and has mostly stayed below the Federal Reserve's 2 percent target over the past nine years. Initially this was viewed as a natural consequence of a weak economy, but more recently it has become increasingly puzzling as to why inflation remains low, even as the economy recovers and unemployment has fallen to 4.1 percent.
Here's the real question we should be asking: Why are we letting economic models that don't seem to be translating to real life affect policy?
Federal Reserve Chair Janet Yellen uses the "Phillips Curve model" to predict inflation. According to this theory, inflation is caused by tight labor markets, which put upward pressure on wages and prices. Conversely, the theory holds that inflation falls during recessions when there is high unemployment.
Because inflation has failed to increase as the Phillips Curve predicts, Yellen and other Fed officials have been searching for special factors that might explain the persistently low rate of inflation.
But the Fed is searching for answers in the wrong place. It needs to look in the mirror.
Start at square one: The fact that the Fed is even responsible for targeting inflation at 2 percent. Why did the Fed take on this duty, and not some other organization?
Obviously, the Fed believes that monetary policy determines the rate of inflation. And there is a lot of evidence that this is the case. Inflation rose sharply when we abandoned the gold standard and adopted a paper money system. Inflation fell when Fed Chairman Paul Volcker adopted a tight money policy in 1981, even though the rest of the government was running large budget deficits.
So monetary policy really does determine the rate of inflation. This means that if inflation is persistently below the Fed's 2 percent objective, the stance of monetary policy is too tight.
Consider an analogy of an ocean liner sailing across the Atlantic toward New York. If the ship went off course, veering toward Boston, whose fault would that be? One answer might be "special factors" such as strong winds, which pushed the ship off course. But at a deeper level, it would of course be a failure of navigation, as the captain is supposed to adjust the rudder to offset the impact of wind and waves.
Similarly, the Fed needs to adjust monetary policy to offset the impact of special factors, whatever they may be, that might have pushed inflation below 2 percent. Ultimately the Fed is, in fact, the only organization that can control inflation.
Surprisingly, the recent undershoot of inflation had occurred during a period when the Fed has been raising interest rates, a policy that is normally aimed at slowing, not increasing, inflation. It's as if a ship captain responded to persistent headwinds by turning the rudder in the wrong direction.
If the Fed wants to hit its 2 percent inflation target, then they need to stop relying on the often unreliable Phillips Curve model, and pay more attention to the way the economy is actually responding to money policy decisions.