Falling inflation will pose a quandary for the Federal Reserve as it attempts to leave the days of emergency stimulus in the past.
At just 0.8 percent annually in December, according to the Consumer Price Index updated Friday, inflation is far below the Fed’s 2 percent goal and dropping.
Other measures of inflation also have showed downward movement, including the Fed’s preferred metric that strips out volatile energy and food price movements.
The question facing Fed Chairwoman Janet Yellen and company is whether the slowdown in inflation is just a product of falling oil and other commodity prices, or a sign that commerce isn’t picking up as fast as they would like.
Commenting on low inflation, Federal Reserve Bank of St. Louis President James Bullard on Friday said “the nature of this surprise pulls the committee in two different directions on monetary policy.”
The improving job market pulls the Fed toward tightening monetary policy. With job creation accelerating through the end of 2014 and the unemployment rate falling to 5.6 percent, Fed officials believe they are nearing their mandate of maximum employment.
The Fed has held short-term interest rates near zero since late 2008 and has bought trillions of dollars’ worth of government bonds in an attempt to boost the recovery. In theory, maintaining low interest rates for too long as the unemployment rate falls could generate rising inflation.
But inflation has been falling, not rising. In recent public appearances, Yellen has attributed the decline in inflation to the drop in energy prices. The price of oil has fallen by roughly half since the summer. Those effects are likely to be temporary, Yellen has said, and inflation will head toward the Fed’s 2 percent goal as the economy improves.
In its most recent meeting, the Fed committee said it would be “patient” in moving toward rate hikes, and Yellen clarified that the move wouldn’t come before the April meeting. Current market expectations are for the first rate increase to come after September.
Nevertheless, at least one Fed official isn’t so sure that falling inflation is going to be temporary.
“We ought to be as concerned about systematically missing our inflation target on the low side as on the high side,” Boston Fed President Eric Rosengren said Thursday.
In an interview with the Wall Street Journal, Rosengren cited bond market prices suggesting that investors expect inflation to remain low and said the Fed risked missing the larger trend in inflation.
“Think about oil prices. In the 1970s we had a situation where we had a negative oil shock, and one of the things I don’t think we captured during the time of the ’70s was how expectations were integrating the oil shock. Central banks were too slow to realize that inflation expectations were moving up,” said Rosengren, considered one of the more dovish members of the Fed system. “The history of this period may be looking at a mistake on the other side, where central banks were not thinking enough about missing on their inflation target on the downside.”
Yellen said in December that “the jury is out about exactly how to interpret” movements in bond market indications of inflation, which also can be shaped, for instance, by investors buying U.S. Treasuries for safety.
To gauge inflation expectations, Fed members instead look at surveys of consumers and forecasters, which have a better track record in predicting price changes.
Deutsche Bank economist Peter Hooper, a former economist for the Federal Reserve Board of Governors, said Friday that the Fed would feel confident raising rates as long as survey-based inflation expectations were stable and unemployment was falling, even if headline inflation remained low.
“They don’t need to see 2 percent inflation to hike rates, they need to believe that we’re headed towards 2 [percent],” said Ethan Harris, co-head of global economics research at Bank of America Merrill Lynch.
But if inflation is still falling by midyear, “it really comes down to a question about whether they believe the Phillips Curve model and other models of inflation or not,” Harris added.
Bullard, however, said that the Fed could raise rates regardless of what’s happening with inflation if job creation and gross domestic product growth are strong enough.
“The level of inflation is not so low that it can alone justify a policy rate of zero,” Bullard said.
