The Mystery of Missing Inflation

Following-up, "Federal Reserve Raises Short-Term Interest Rates."

At the Wall Street Journal, "The Mystery of Missing Inflation Weighs on Fed Rate Move":

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...

Raising rates might restore a little stability to the economy, especially on housing. It's not a bad thing. And for goodness' sake, a 1/4 point increase is virtually unnoticeable.

More.