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 Fed officials have said that they do not need to see prices
accelerate to start raising rates after six years near zero, and
"lift-off" appears nearly ordained by a 5.3 percent unemployment
rate, the lowest since April of 2008.
But it would be a leap of faith to move any further without proof
that prices are on the rise, say current and former officials
familiar with the central bank's debate and the current state of
inflation research.
If prices remain stalled as the Fed tightens, inflation-adjusted
"real" rates would rise faster than the Fed wants, and threaten the
recovery. Given the uncertainty among economists about how inflation
works in the post-crisis world, it may be risky to assume higher
prices will necessarily follow a tightening job market. (Graphic:
http://graphics.thomsonreuters.com/15/fed-rates/)
"There is a big component of inflation that is just going to be
idiosyncratic and unexplained," leaving policymakers to take their
best guess about it, said former Fed research director David
Stockton.
He said that after an initial rate increase, Fed Chair Janet Yellen
would lead her colleagues on a "cold, dispassionate examination" of
what the inflation data are actually showing.
"If inflation is not moving back to target ... then she can argue
for a go-slow approach."
NEW DYNAMICS
Inflation will be the key topic at the Fed's annual Jackson Hole
economic conference on Aug. 27-29 and the gathering is likely to
highlight how little policymakers and economists feel they
understand about the behavior of something so central to monetary
policy.
Inflation did not fall as much as expected during the 2007-2009
recession, it has not risen as much as expected during the recovery,
and there is suspicion it may remain hard to budge, said Michael
Owyang, an assistant vice president at the St. Louis Federal Reserve
Bank.
"There has been a lot of new research. Volumes of new research. And
I am not sure there is a consensus about how policy affects
inflation at the zero lower bound," Owyang said, referring to the
fact that the Fed's benchmark has been held near zero since late
2008. "Inflation dynamics have changed."
The rest of the world is not helping. A weak global economy has
depressed world commodity prices. The prospect of the Fed raising
rates has boosted the dollar, further undercutting inflation through
lower import prices.
That has confounded the Fed's forecasts for a year now, and
according to minutes of its July meeting remains a central concern -
and one of the risks that could delay an initial rate hike beyond
the Sept. 16-17 policy meeting. After the minutes laid out the
internal debate about inflation, investors cut their expectations
for a September "liftoff" in favor of December.
The Fed, keen to move away from zero and create some policy wiggle
room, may still move. But at some point it needs inflation to do so
as well.
THIN CUSHION
Part of the logic of the Fed's 2 percent inflation target is to
allow the central bank to lift its benchmark rate and build a
cushion for monetary policy to respond to any new economic threat
without letting inflation-adjusted rates go up too much. The Fed's
estimated "neutral" federal funds rate of around 3.75 percent is
premised on inflation rising to target, and unless it does the
tightening cycle will have to go slow, or stop altogether.
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"Seeing inflation converge ... will clearly be an important signpost
for us as we are looking at decisions to be made post-liftoff," said
Atlanta Fed President Dennis Lockhart.
The Fed's latest forecasts see inflation hitting the 2 percent goal
in 2017, and interests rates reaching a neutral level sometime in
the next year.
Inflation was a mere 0.3 percent in the second quarter, and even the
Fed's preferred gauge, that excludes volatile food and energy
prices, stands at 1.3 percent and has been falling since 2013.
Recent research shows how much the inflation landscape has changed.
Falling unemployment and consequent wage increases, for example, no
longer drive near-term inflation as they did in the 1960 and 1970s,
according to research at the Fed's Washington-based board. That
possibly reflects labor's declining share in the value of goods, or
the fact that a tightening labor market no longer translates
dependably into significant wage increases.
Studies also show a break between the unemployment rate and
short-term inflation some time in the 1990s, with price increases
flattening out and impervious to fluctuations in the employment
level.
Consumer and business expectations, meanwhile, are thought to play a
larger role.
Since 2007, a series of shocks have also weighed on prices,
beginning with the U.S. financial crisis, followed by the euro
zone's debt troubles, China's economic slowdown, a world commodity
rout and households' efforts to reduce debt and save more.
The success of Yellen's tenure may hinge on whether she and other
Fed officials are correct in their view that all of this will prove
temporary, that the U.S. economy is more "normal" than it might seem
- and that tight labor markets will ultimately spark price
increases.
The conviction is rooted in the decades-old, mainstay theory that
there is an inverse "Phillips curve" relationship between
unemployment and inflation. The relationship seems to have weakened
over the years, and some argue Yellen should seek more proof about
inflation - or risk a potential policy mistake.
The argument to raise rates now relies on “a strong presumption that
the employment goal is close at hand, the Phillips curve is working
as usual, and the risks are nearly balanced," said Andrew Levin, a
former adviser to the Fed board who now teaches at Dartmouth
University. "Unfortunately, if those assumptions are wrong, then by
next summer the funds rate could be at 1 to 1-1/2 percent before
it's clear they’ve made a mistake.”
(Editing by Tomasz Janowski)
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