The Fed believes temporary factors are goosing the inflation rate
The U.S. economy, by all indications, is near full employment, and, according to the inflation hawks, that means inflation rates should start rising again.
In fact, the hawks say, inflation is already bubbling, and, if Janet Yellen doesn’t cool things fast, inflation will be at a full boil. Very soon, the hawks say, the inflation rate will exceed 2%, which is the Federal Reserve’s target rate.
Inflation has been below 2% for four years, which is one reason the Fed is keeping money so easy. Most Fed officials don’t think inflation will get back to 2% on a sustainable basis for two more years.
What’s behind this recent uptick in inflation? One theory is that we have too many jobs. That is, economic theory suggests that when the unemployment rate gets very low, workers gain bargaining power and are able to command higher wages because the demand for labor is higher than the supply. Bosses must raise wages to keep good workers, and then they must raise their selling prices in order to pay those wages.
This relationship is known as the Philips Curve, and it’s been the main theory behind the Fed’s monetary policy for more than 50 years: The Fed tries to keep the unemployment rate just above the level that would fuel inflation. That level is known as the nonaccelerating inflation rate of unemployment, or NAIRU.
There’s only one problem. Although the theory seems quite reasonable on a chalkboard, the empirical evidence shows that it doesn’t work in the real world. NAIRU seems to change over time. Sometimes it seems that NAIRU is above 6%. But right now, NAIRU seems to be below 5%. It could be below 3%. Recent research cited by the Council of Economic Advisers suggests NAIRU could be zero. No one really knows. And no one has a better theory to explain inflation.
So far, Fed officials are doing what seems most practical: They are letting the economy run. Before they feel obligated to slam on the brakes, they’ll want actual evidence of higher prices and higher wages. They’ll cautiously raise rates away from zero but maintain accommodative policy for a while longer, especially with risks of global contagion rising.
But what about the spike in the PCE price index in the past few months? Surely that indicates that NAIRU has been breached! Isn’t it time to get serious about raising rates?
Fed Chairwoman Janet Yellen was asked about that at her latest press conference on Wednesday and she said she wasn’t convinced.
“Given that the economy is now close to our maximum employment objective, hopefully inflation is moving up,” Yellen said, before switching to the other hand. “As you mention, recent readings on inflation have moved up. There may be some, you know, I want to warn that there may be some transitory factors that are influencing that.”
In other words, just as transitory declines in oil prices and the one-time strengthening of the dollar have pushed the PCE price index far below the Fed’s target, transitory increases in other prices are now pushing the index higher. But Yellen doesn’t think it’ll last, in either case. Oil prices and the dollar will stabilize, and the transitory price increases seen over the past few months will also fade away.
Now, this may seem like cherry picking the data: Yellen picks which prices matter to her, and disregards the rest. But there is a method to her madness.
Remember, inflation is a general and sustained increase in prices, not just temporary increases or decreases for a few goods and services. What the Fed cares about, what we care about, is the pace of underlying inflation. Transitory spikes or dips aren’t generalized inflation; that’s just the markets working out the ebbs and flows of supply and demand.
Economists have a lot of tools to help them figure out whether the underlying rate of inflation has changed or whether it’s just temporary factors. One method is to use core inflation measures, which automatically ignore volatile food and energy prices. Core inflation does a pretty good job of predicting future inflation rates, but it offends people who think food and energy prices matter in the real world.
Another method has been devised by the Dallas Fed. Its trimmed mean PCE index strips out whatever prices are rising or falling most in a given month, ignoring the outliers on the theory that the biggest price changes are reactions to shocks in individual markets, not part of a general trend.
Researchers at the Dallas Fed point out that the recent spike in the PCE index has been driven by unusually large price increases for goods such as apparel, jewelry, motor vehicles, and drugs, and for services such as air fares, school lunches, tickets for spectator sports and banking fees.
Apparel prices, for instance, are up at a 14% annual rate in the first two months of the year, compared with a 0.9% decrease in 2015. Jewelry and watch prices are up at a 62% annual rate, compared with a 0.7% drop in 2015. Motor vehicle prices are up at a 3.2% rate, compared with a 0.2% rise last year. Drug prices are up at an 11.5% rate, compared with a 1.7% increase last year.
Most likely, the recent spike in the PCE index is due to temporary shocks, not to an acceleration in underlying inflation. There’s no urgency to raise rates on account of hyperinflation lurking right around the corner. In reality, the Fed would be ecstatic if it could get inflation back to 2% any time soon.