The Quandary on Inflation

In recent congressional testimony, Chair Janet Yellen expressed dismay that inflation has remained persistently below the Fed’s target of 2% despite years of monetary stimulus and a decline in joblessness to its lowest level in more than 40 years. Granted, all data have anomalies and measurement issues, yet the recent shortfall in US inflation (see Figure 1) seems strikingly ‘abnormal’ relative to that of recent years, especially in the context of a tighter domestic labour market and comes at an awkward time as the Fed has set course for an historic unwinding of its extraordinary policies of the past eight years. Will low inflation derail the Fed’s exit strategy? If not, where are they headed?

Notwithstanding the fascination of market observers with quandary presented by the latest undershooting, the Fed is not likely to give up on the notion that inflation will begin to rise now that the economy has reached its potential – at least not yet. One of the most enduring relationships in macroeconomics has been the link between the so-called output gap and inflation depicted in Figure 2 on the next page. Note, however, the delayed response of core inflation even after real GDP exceeds its inflation-stable potential (i.e., the output gap measured on the left-hand scale crosses its target of zero.) This seemingly perverse lag can be seen during the late 1990s and again in 2003 when inflation actually declined after output had already surpassed potential. On average, the delayed reactions can last for one year, so this latest undershoot is not yet cause for FOMC members to lose faith in this relationship.

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