Inflation Amnesia Threatens the Fed

Low inflation is feeding into consumers’ price expectations, setting up a challenge for the Federal Reserve

By Justin Lahart

Inflation has been low for so long, Americans are getting used to it. For the Federal Reserve, that is a big problem.

The Fed assumes inflation is about to heat up but instead it is running cold. The Commerce Department on Friday said its measure of consumer prices—the Fed’s preferred inflation gauge—was up just 1.4% on the year in May. The core measure, which excludes food and energy prices to better capture inflation’s trend, was also up 1.4%, marking its slimmest gain since late 2015.

As usual, there are arguments that transitory factors, such as lower costs for wireless plans, may be pulling overall prices downward. Other shifts, such as falling apparel prices, don’t seem so temporary. If inflation is going to reach the Fed’s 2%, it is going to take time.

The problem for the Fed is that regardless of what is keeping prices down, the longer inflation stays low, the lower people’s inflation expectations go. Those low expectations feed into actual prices, because even during times of low unemployment—such as now—people don’t demand as many wage increases and they don’t spend now in anticipation of higher prices later.

Investors’ inflation expectations have been running cold for a while now. The Treasury market implies that the Labor Department’s consumer-price index (which runs hotter than the Commerce Department’s gauge) will post an average gain of about 1.7% over the next decade.

What is more worrisome is that consumers’ inflation expectations have been grinding lower. On Friday, the University of Michigan said consumers it surveyed in June expect inflation to average 2.5% over the next five years, a bit higher than the 2.4% they expected in May, but a half point lower than what they forecast in 2007.

Consumers’ forecast of 2.5% inflation is, of course, higher than the Fed’s 2% target. But consumer inflation forecasts are consistently above prevailing rates. Economists at Evercore ISI suggest that a weakening trend in many services prices is consistent with actual inflation expectations that are about a quarter point short of the Fed’s target.

A quarter point short might not seem like all that much, but it could cause some real problems for the Fed. If it wants to push expectations back up, it may need to leave policy looser for longer—and risking speculative excesses building as a result.

But if it settles for inflation at 1.75%, it not only would hurt its credibility over its inflation target, it would be setting the economy’s just-right level of overnight interest rates a quarter point lower. Then, when the next recession came, as it someday will, it would have a quarter-point less in cuts before interest rates hit the zero bound.

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