The Controversy Over Inflation

“This is one of the most important questions facing monetary policy.”

Chairwoman of the Federal Reserve Janet Yellen
Joshua Roberts / Reuters

This week, the Federal Reserve decided to raise interest rates, a move intended to slow the economy down. It makes some sense. The current spell of growth has lasted for nearly 100 months. The jobless rate is down to 4.3 percent, and less than 2 percent in some metro areas. Wages are increasing, though not by much more than inflation. The monthly jobs numbers continue to look decent. As such, as expected, the Fed raised its benchmark rate by a quarter of a percentage point, from 1 to 1.25 percent.

But there is one main indicator that does not signal an economy getting hot—and it is one that the Fed is supposed to be keeping an eye on just as closely as it keeps an eye on employment. That is inflation. Price increases have proven remarkably, persistently sluggish, with inflation lower than the Fed itself says it would like it to be. The central bank currently has an inflation target of 2 percent, and yet, excluding volatile food and energy prices, as the Fed likes to do, inflation is a few tenths of a percentage point below that mark—and falling, no less.

This poses a quandary for the Fed, and about the Fed. Why is inflation so low if the economy looks so good, judging by other metrics? And why would the Fed raise rates—cooling the economy off and potentially keeping thousands of workers from joining the labor force, getting a gig, or getting a raise—given that inflation is so low?

The root causes of today’s low rates of price growth might be mostly benign. The Fed itself argues that the sluggishness is in part due to temporary or one-time price drops, and thus not something to get worried about. “The recent lower reading on inflation [has] been driven significantly by what appears to be one-off reductions in certain categories of prices such as wireless telephone services and prescription drugs,” Janet Yellen, the Fed chair, said at a press conference this week.

International factors might be at play, too. The strength of the dollar, ample cheap imports from abroad, technological change, and the slow growth of the global economy might be helping to hold inflation down. “Progress toward reaching our 2 percent inflation objective has been slow over the past several years,” said Robert Kaplan of the Dallas Fed. “I believe this has likely been due to a rising dollar and weaker energy prices, as well as a number of persistent secular forces, such as globalization and technology-enabled disruption.”

A third potential reason is more disheartening: The economy might just not be that good for that many people. The marquee unemployment rate is as low as it has been since 2001, but the employment-to-population ratio for people in their prime working years remains far below where it was before the Great Recession hit. Discouraged workers might be sitting at the fringes of the labor market. More broadly, the economy is growing consistently, but not particularly quickly—nor has it been at any point during the recovery. And many workers still are not seeing the kind of wage and income gains evident in other recoveries.

Finally, the Fed argues that conditions are ripe for inflation to pick up—it just might not have happened yet. The jobless rate is quite low, employers are starting to complain that they cannot hire workers at a given wage, and optimism is high. Inflation might be just around the corner, the thinking goes. “There are good reasons to expect that inflation will resume its gradual rise. Incoming spending data have been relatively strong, and the labor market should continue to tighten, exerting some upward pressure on wages and prices,” said Jerome Powell, a Fed governor, at a speech this month.

Still, none of this explains why the Fed has tolerated inflation being so low for so long. Core inflation has remained below the Fed’s target for nearly all of the recovery. At the same time, the central bank has repeatedly estimated that inflation would tick up, only to see it remain sluggish. The bank says that it wants to have a “symmetric” inflation target, with the rate bobbing above and below the 2 percent mark. Yet it seems content to let it sink below 2 percent and stay there.

For that reason, a prominent group of left-of-center economists—including the former Obama adviser Jason Furman and the Nobel laureate Joseph Stiglitz—are calling for the Fed to consider boosting its inflation target higher than 2 percent, to account for all those undershot years. As the Fed kept interest rates at zero “for seven years without sparking any large acceleration of aggregate demand growth, a reassessment of this target seems warranted,” they wrote in a public letter to Yellen. “Such a reassessment is particularly appropriate when the lack of evidence that moderately higher inflation would harm Americans’ standard of living is juxtaposed with the tremendous evidence that a tighter labor market would improve Americans’ standards of living.”

This week, Yellen was receptive to that sentiment. “This is one of the most important questions facing monetary policy,” she told reporters, saying that the Fed would look closely at whether it made sense to boost the target.

For the meantime, though, it continued with its well-broadcast plan to lift interest rates, normalize monetary policy, meet financial markets’ expectations, head off any jumps in inflation, and prevent the need for bigger rate increases down the road. A quarter-point increase on an extremely low interest rate will not do much to sap economic growth, of course. But it remains unclear whether the Fed is right to want to do so at all.