Lost Inflation—Let the Fed Know If You’ve Seen It

The decade-long lack of inflation—even in the face of recent roaring jobs reports and a relatively robust economy—continues to perplex the Federal Reserve. Because low to moderate levels of inflation are good (they allow companies to pay higher wages, for example), the Fed may start looking at ways to redefine its 2 percent price stability target.

Over the past two years the nation’s central bank has focused on keeping ahead of anticipated inflation by hiking short-term interest rates. Raising rates also offers a tool to fight recession—the ability to cut rates (although the Fed usually has to slash interest rates by 5 percent to stimulate the economy during a slump, and with current rates can only reduce them by 2.5 percent right now).

What’s Behind the Mystery?

But the Fed now finds itself in a quandary—mostly because inflation has failed to materialize and no one answer explains its demise.

• Is it because consumer prices are less tightly linked to what’s going on in the real economy than in the past?
• Does the labor market actually have more slack, meaning the Fed’s unemployment target should be under 4 percent (especially with projections that unemployment will average 3.5 percent by year’s end)?
• Are prices really being depressed by technology that allows existing assets to be used more efficiently?
• Or all of these?

Do the Aussies Have It Right?

The Fed currently tries to hold annual inflation at 2 percent. Now, some Fed members see advantages to setting an average 2 percent inflation target so they can increase inflation when the economy needs it (like now) without making the market question whether they’ll keep it under control after conditions improve. For instance, if over a certain period inflation rolled in below 2 percent and prices ended up 7 percent lower than would be expected, the Fed could try to boost inflation for a short time to erase the gap between actual and target growth.

While a huge shift in approach, it might just work. The only country that tackles inflation this way—Australia—hasn’t had a recession since 1991.