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 The soft global inflation backdrop, from sliding oil prices to
stagnant wages in advanced economies, has triggered debate over
whether the Fed and its peers merely need to wait for a slow-motion
business cycle to improve, or face a shift in the underlying nature
of inflation after the global recession.
That uncertainty has become the Fed's chief concern in recent weeks,
likely to shape upcoming policy statements and delay even further
the moment when interest rates, pinned near zero for nearly six
years, will start rising again.
Investors have already pushed expectations for an initial rate hike
back several months to late next year because of a dimmed global
outlook. The Fed is expected to take note of recent market turmoil
and worsened world conditions at its Oct 28-29 meeting even as it
ends the bond-buying program launched to fight the financial crisis.
Yet if the Fed keeps struggling getting inflation back to its 2
percent goal it could prompt a deeper rethinking of its approach.
That could involve an even more open-ended commitment to low
interest rates, the renewal of asset buying to pump cash into the
financial system, or more aggressive language to encourage
households and businesses to invest and spend.
 Inflation was already acting out of character during the 2007-2009
recession when it fell less than expected. Now, its glacial movement
during the recovery suggests something basic may have changed, San
Francisco Fed President John Williams told Reuters last week.
"Either it is because inflation is no longer a good judge of
(economic) slack or there are some other factors" yet to be
understood, he said. "These are things we are trying to understand -
what is structural, what is cyclical."
Williams said he still expected that eventually "Economy 101" forces
of supply and demand would regain traction, and push up wages and
prices around the world.
What if they don't?
That would put the Fed in a bind - with rates at zero, and absent a
renewal of the sort of unconventional programs it has been trying to
wind down, no tools at hand.
The experience of its Japanese and European peers is far from
encouraging.
UPHILL STRUGGLE
The Bank of Japan pulled the economy out of a protracted deflation
with a massive burst of stimulus, but its inflation goal remains
elusive, leaving it with an open-ended promise of extra loose policy
for however long it takes. A similar fight has been underway in the
euro zone now for five years.
Fed officials say they are confident the U.S. economy is turning a
corner, and have stuck with forecasts showing a gradual rise in
inflation over the next year or two that would allow a slow but
steady rise in interest rates.
But they have yet to fully explain what has happened in the U.S.
economy in the past two years: how a much faster than expected fall
in unemployment squares with a much slower than expected rise in
inflation. They have also struggled to describe what they might do
next - eager to lay the groundwork for an initial rate rise, yet
uncertain whether and when it will be possible.
"The Fed is trying to feel this one out...They are trying to be as
non-committal as possible," said TD Securities analyst Gennadiy
Goldberg. "They don’t know when inflation will pick up and when
disinflation pressures will stop."
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Central banks seek to maintain a steady, moderate inflation to keep
wages and spending growing, lower relative costs of debt and allow
them to use interest rates as the main policy lever. Fed officials
acknowledge that if inflation weakens further, they might need to do
more by strengthening their commitment to keep rates low for longer
or, in an extreme case, revive the bond buying program. While that
is not their forecast, the recent market dive and Europe's weakness
reopened a conversation U.S. central bankers thought they had left
behind.
"If we don’t see wage growth or the price inflation that I am
looking for then it would be appropriate in my view to further
stimulate aggregate demand," said Williams, who was one of several
Fed officials in recent days to note that if the economy veers off
course they will respond.
Research at the Fed and elsewhere in recent years has delved into
how the evolution of the global economy may have changed the way
wages, prices and output interact.
Among the possible forces at play, Fed research has noted a steady
decline in workers' share of U.S. national income, a result of the
shift of manufacturing jobs overseas, technology investment that has
raised productivity faster than wages, and perhaps even the decline
of labor unions and their bargaining power. The drop in labor's
share, which is expected to continue, means wages no longer drive
inflation as much as they did in the past.
"You are not seeing the type of wage pass through dollar for dollar
you used to see. The dynamic has just changed," said Sheryl King,
senior director of research at Roubini Global Economics.
Outsourcing of production and, increasingly, services overseas may
continue to temper inflation; the increasing use of part-time labor,
the more rapid rise of lower paid work and automation could also be
at play.
All told, the cross-currents are hard to read. The drop in oil
prices helps energy intensive firms and consumers, but it could also
be a symptom of global economic weakness and dent investment in a
thriving sector of the U.S. economy.
"From the perspective of the 1970s you'd say this is crazy. Because
normally slack gets removed much more quickly, and you would have
stronger inflation," Chicago Fed President Charles Evans said in
Indiana last week. "That does not seem to be anything like what we
are experiencing now."
(Editing by Tomasz Janowski)
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