Nobody seems to know why there’s no US inflation
As the Federal Reserve meets this week, officials are flummoxed by restrained price rises
by Sam Fleming in Washington
Ron Paul, at least, has no regrets. The former Texas Congressman is one of the most prominent voices among those Americans who have long been deeply suspicious of the US central bank and its power to print money. When he ran for president in 2012, he assailed then Federal Reserve chairman Ben Bernanke for debasing the currency and risking an inflationary upsurge by pumping trillions of dollars into the financial system.
“We don’t have prices in the consumer market going up like in the 1970s but we should not be surprised if that happens,” says Mr Paul, who once brandished a silver coin as he lectured the former Fed chair on Capitol Hill.
Elsewhere, certainty is harder to come by. As the Fed meets in Washington tomorrow, US central bankers, and their counterparts across the world, are genuinely flummoxed by recent low inflation readings.Despite a recovery that is now the third-longest on record, America is trapped not in a 1970s-style, double-digit inflationary upsurge, but a slow-inflation quandary.
Price growth jumped in August, driven by energy and accommodation prices, yet investors still doubt inflation will be strong enough to merit more than a couple of interest-rate rises before the end of 2018.
The uncertain outlook has confounded Fed policymakers just as the central bank prepares for a leadership overhaul in the new year. President Donald Trump, who will decide shortly on the replacement for current Fed chair Janet Yellen, has managed to be on both sides of the question — slamming low rates last year during the election but welcoming them this year.
“It is a puzzle and raises a real question what the Fed should do next; I would have thought we would have been seeing more inflation pressures by now,” says Jon Faust, a former adviser to Ms Yellen at the Fed now at Johns Hopkins University. “At a time when there is a confusing economic picture we don’t know who will be judging that picture in a few months’ time at the Fed. That added uncertainty is not a good thing.”
Having lifted rates twice this year in the face of this dreary inflation, the Fed is expected to keep the target range for its key rate at 1-1.25 per cent on Wednesday, even as it announces the gradual unwinding of its quantitative easing programme. Ms Yellen is likely to leave open the prospect of a further rate rise in December, as she banks on diminishing slack in the economy driving up prices amid a global growth rebound.
Yet the Fed’s 2 per cent inflation target still appears out of reach — stripping out food and energy costs, it has not attained that rate for half a decade. It has been a quarter of a century since the Fed’s favoured measure of inflation — personal consumption expenditures excluding food and energy — last punched up above the still relatively sedate level of 3 per cent. It was just 1.4 per cent in the year to July. Wage growth, meanwhile, remains well below its pre-crisis pace at just 2.5 per cent.
In 2015 Ms Yellen set out a clear road map to higher goods and services inflation, making the traditional central bankers’ argument that diminishing spare capacity would ultimately stoke up price and wage pressures. The trouble is that even as the economy grows steadily and joblessness falls to 4.4 per cent, inflation has this year undershot the levels suggested by her model.
Part of the problem is that the link between low unemployment and higher price growth embodied in the so-called Phillips curve has looked fragile for decades. Some officials suspect the Fed can afford an even stronger labour market without worrying about excessive price growth.
On one level, sluggish inflation combined with respectable growth is far from a bad thing — central bankers in the 1970s would have looked on the current paradigm with envy. But if inflation hovers too low it leaves the economy uncomfortably close to deflation and could damage the credibility of an institution that is meant to target 2 per cent inflation. Low rates and low inflation leave little rate-cutting firepower when the next downturn strikes.
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Weak inflation may also prompt the central bank to leave policy so loose that it inadvertently stokes up a cycle of boom and bust — something the Fed has repeatedly been accused of doing in recent decades. That worry has reasserted itself thanks to soaring asset valuations. “The risk is that you are going to end up with interest rates that are too low relative to what is consistent with financial and macroeconomic stability,” says Claudio Borio, head of the monetary and economic department at the Bank for International Settlements. “If inflation doesn’t show up, it will be hard to move interest rates up at the right speed to address this issue.”
A five-month-long string of weak figures this year has prompted some Fed policymakers, including Bill Dudley of the New York Fed and Rob Kaplan of the Dallas Fed, to start asking searching questions. Are globalisation and technological advances restraining inflation at a time when a cyclical pick-up might otherwise drive it higher?
“These two forces are colliding,” Mr Kaplan told the Financial Times last month. “The cyclical forces we have understood historically; the structural forces are somewhat new, particularly technology-enabled disruption.”
Some policymakers cite the increased ease with which shoppers can compare prices on the internet and the impact these changes have on brand loyalty and pricing power. Amazon is entering grocery retail via Whole Foods, while the hotel sector is being overturned by Airbnb.
Rick Rieder, chief investment officer of fixed income at BlackRock, sees more price disruption to come, as artificial intelligence promises to further transform some industries.
Research from Adobe Analytics shows what online competition is doing in some fields. Online prices of furniture and bedding are down 8.3 per cent over the past two years, whereas the equivalent category in the consumer price index, which includes offline sales, has dropped less than half that amount. Sporting goods prices online are down 10 per cent, compared to 3.7 per cent in the CPI. Online clothing prices are down 6.5 per cent in the same period, compared with a 4.1 per cent offline drop.
Janet Yellen is likely to leave open the prospect of a further rate rise in December © FT montage / Dreamstime/Bloomberg
Goods price deflation is not new in the US, and Pete Klenow of Stanford University says comparisons between online and offline prices baskets can be tricky because of their different constructions. While some Fed officials argue that technology is eroding companies’ ability to lift prices, Goldman Sachs analysts recently found an increase in corporate pricing power over the past 20 years, consistent with a rise in profit margins and industry concentration.
Goldman economists also question arguments that ecommerce, which accounts for around 8 per cent of retail sales — is having an appreciable impact on broader inflation. The effects of online competition on traditional retailers’ pricing may be no larger than those seen during the rise of “big box” superstore chains like Walmart.
Other analysts have been looking closely at the labour market, linking paltry wage growth to the soggy inflation readings. Catherine Mann, the chief economist at the OECD, the Paris-based club of mostly rich nations, says higher job insecurity and lower labour force mobility in the US may be stifling calls for higher wages. “Workers and producers are unsure that the market is actually going to be robust enough to support higher wage and price demands.”
While goods price inflation has been negative for much of the post-crisis period, Ms Mann highlights a weakening in services price inflation from 3 per cent before the crisis to closer to 2 per cent now. She is examining the growing role of services jobs held disproportionately by women who are paid less than men. “It is really tough to get inflation up if wages are not rising,” she says.
At the Fed, some officials struggle to see why big structural factors would have intervened to crush inflation numbers. Instead, the Fed has suggested this year’s dull outcomes are being driven by a series of coincidental, one-off drags, including a fall in wireless data prices.
If they are right, the jump in inflation last month could herald further gains — with an extra lift potentially from the recent dollar depreciation. Yet Fed rate-setters are split over the outlook, and market confidence in Fed forecasts has ebbed. Charles Plosser, a former president of the Philadelphia Federal Reserve, says: “I do think economists need to work harder on understanding the inflation process.”
The shortfalls are by no means confined to the US. In the euro area, a sharp drop in unemployment across the region is yet to be matched by a strong pick-up in wages — without which officials fear inflation will fail to hit its goal of just under 2 per cent.
Mario Draghi, president of the European Central Bank, said this year that “backward-looking” negotiation of nominal wages that reference low inflation rates may be restraining prices. Many of the new jobs are also in temporary or part-time employment, which may slow the growth of nominal wages as well. At the Bank of Japan, meanwhile, officials’ struggles with achieving inflation targets are well documented.
In the US, whose monetary policy has global reach, questions about inflation are compounded by the uncertainty over who will call the shots from February. Mr Trump will have the opportunity to appoint up to five new Fed board members by next year, but attempting to predict his choices seems futile given the capricious nature of his personnel decisions.
Some analysts argue that the central bank could end up drifting in a hawkish direction — which would worry economists with a firm eye on low inflation. Mr Trump may not reappoint Ms Yellen, who inhabits the dovish end of the policy spectrum. A number of the alternative candidates for chair have shown signs of more hawkish leanings — among them the Stanford academics Kevin Warsh and John Taylor.
On the other hand, Mr Trump has called himself a “low-rates person” and there are precedents for presidents leaning on Fed leadership to keep policy loose — even when inflation threatens to start to pick up. Richard Nixon pressured Arthur Burns to keep rates low in the early 1970s, for example. While an inflationary upsurge may currently seem unlikely, economists have such a thin grasp on what drives inflation that it is far from impossible — as observers including Mr Paul continue to warn.
If inflation fails to reassert itself, the Fed and other central banks will find it harder to balance the need for low rates against the hazardous side-effects loose policy engenders in markets. Mr Faust says: “If the central bank keeps pushing it can make inflation go up — but the question is whether some other excess bubbles up first.”
The low-inflation enigma looks set to continue bedevilling policy not only in the US but across the world.
Additional reporting by Claire Jones in Frankfurt
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