WASHINGTON—The United States has a problem: not enough inflation. That notion is a bit of a head-scratcher. Most people don’t like inflation. They would prefer that a dollar tomorrow be worth the same as a dollar today.
But a recent drop in inflation may be a sign of fresh economic weakness and is perplexing to Federal Reserve (the Fed) officials who are wrapping up the central bank’s stimulus campaign.
The Fed thinks modest inflation has important economic benefits, and it has aimed since 2012 to keep prices rising at an annual pace of 2 percent. The problem is that the Fed is on track to fail for the sixth straight year. Inflation has been stubbornly sluggish.
A little inflation can brighten the economic mood, causing wages and corporate profits to rise more quickly.
Economists like to point out that this is an illusion. If everyone is making more money, then no one can buy more stuff. Prices just go up. But the evidence suggests people enjoy the illusion and, important, they respond to the illusion by behaving in ways that increase actual economic growth, for example by working harder.
The Fed chairman, Janet L. Yellen, told Congress this month that she expects inflation to rebound. But she said the Fed could change course if weakness persists, by, for example, not moving forward with additional interest rate increases.
“It’s premature to reach the judgment that we’re not on the path to 2-percent inflation over the next couple of years,” Yellen said. “We’re watching this very closely and stand ready to adjust our policy if it appears the inflation undershoot will be persistent.”
The Fed’s policy-making committee will meet on Tuesday and Wednesday, but it is expected to defer major decisions until later in the year. Analysts expect the Fed to announce in September that it will start to reduce its holdings of Treasury’s and mortgage bonds. The Fed is expected to leave its benchmark interest rate unchanged at least until December.
“If you see inflation running below target persistently, for so long, it’s really hard to get around the idea that, despite everything, monetary policy has actually not delivered sufficient accommodation,” said Peter Ireland, an economist at Boston College. “It’s a reason not to clamor for additional rate hikes on top of what we’ve already seen.”
The US learned to fear inflation in the 1970s. It was a period of profound economic uncertainty. Prices rose up to 10 percent a year, and restaurants used stickers to update prices on menus. High inflation encouraged people to borrow heavily and spend quickly; it discouraged long-term planning and investment, and corporate profits fell sharply.
Under Paul Volcker, the Fed gradually brought inflation under control by driving the economy into a deep recession. By the mid-1990s, it seemed plausible the Fed could eliminate inflation completely. But Yellen, then a new Fed governor, was among those who argued successfully that it would be better to maintain moderate inflation.
A little inflation helps the economy rebound from recessions. It gives the Fed more room to reduce borrowing costs, and it also eases necessary economic adjustments. Employers, for example, can cut costs by holding wage increases below the inflation rate.
Inflation can also brighten the economic mood by raising wages and profits more quickly.
And a little inflation also keeps the economy at a safe distance from deflation. When prices fall, growth tends to stall as people wait for even lower prices.
The current debate, however, is mostly about inflation’s role as an economic barometer.
Fed officials began the year expressing confidence that inflation was finally rebounding as the economy continued to expand. But the Fed’s preferred measure of inflation declined in the last three monthly reports, from an annualized pace of 2.1 percent in February to 1.4 percent in May. The inflation gauge is published by the Commerce Department.
Job growth remains strong, but recent reports on cautious consumer spending and business investment suggest that overall growth remains tepid. A turn toward stronger growth again has failed to materialize. The Federal Reserve Bank of Atlanta, which predicted the economy would expand at an annualized pace of 4 percent in the second quarter, now estimates second-quarter growth was 2.5 percent.
Image credits: AP/Richard Drew