Executive Summary: While policy makers at the fed were in general agreement when they raised rates in June, there is increasing divergence about the necessary degree of urgency in continuing to raise rates going forward owing to persistently low inflation. While Chair Yellen hopes that recent weakness in the inflation data reflects one off developments, ongoing technological advancements and caution on the part of consumers present secular headwinds to achieving higher inflation. It appears inflation is an increasingly global process. The benefit is lower and more stable inflation nearly everywhere. The downside may be that domestic monetary policy is losing its potency and, like inflation, low and stable rates may be with us for some time.
The Federal Reserve just raised their target short-term interest rate this month for the fourth time this recovery. The target federal funds rate serves as one benchmark for pricing all interest rates that affect business and consumer borrowing and it now stands at a range of 1.0% to 1.25%, which is still quite low by historical standards (Figure 1). Coming out of the June meeting, participants in the Federal Open Market Committee that sets interest rates have expressed diverging views about the urgency for further interest rates in the near future. The debate centers around the fact that inflation is low. The Fed’s preferred gauge of trend inflation for consumers, the core personal consumption expenditure (PCE) price index, has been below the Fed’s 2 percent target for the past five years and has recently turned lower despite a strong labor market and economy (Figure 2). Chair Yellen was fairly dismissive of the low state of inflation in her press conference citing “one off reduction in certain categories of prices such as wireless telephone services” and indicating that with “the labor market continuing to strengthen, the committee still expects inflation to move up and stabilize around 2 percent”.
Not everyone on the FOMC is convinced. Chicago Fed President Charlie Evans called recent inflation data “disappointing” and indicated that the Fed can “afford to sort of wait a little bit and see how the data play out…to see if inflation’s going to move up.” Dallas Fed President Robert Kaplan indicated that while he supported the June rate hike, he would also like to see data confirming that the recent weakness in inflation is temporary before proceeding with the next increase in the federal funds rate. The bond market is also skeptical that low inflation is likely to prove transitory and that the Fed will proceed with its rate hiking campaign. Markets estimating inflation will average only 1.6% over the next five years and are pricing roughly 50% odds the Fed raises rates again this year with less than two rate hikes priced before year end 2018. Market expectations stand in contrast to the Fed’s own guidance that inflation will average closer to 2.0% and there will be an additional four rate hikes between now and year end 2018.
As Chair Yellen suggested, the price of cell phone service has indeed plunged 12% at an annual rate in recent months as compared to a roughly 4% ongoing pace of decline reflecting a price war this year among major and discount carriers. Cell phone service as measured in consumer price indexes reflects not only the sticker price of a service plan, but also the characteristics of the plan, so the fact that more carriers have been offering plans with unlimited data places additional downward pressure on the true cost of the plans offered. Cell phone services represent only 1.5% of the consumer basket as captured by the core inflation index and the plunge accounts for no more than a quarter of the recent moderation in core inflation. The declining cost of cell phone service captures two broader trends in price setting that may prove to be more structural than cyclical. The first is technology which allows for the production of higher quality consumer goods and services at a lower cost and lends an ongoing downward pressure to the prices of consumption items from cars to televisions to cell phone service.
The second headwind to inflation trends is ongoing price sensitivity among consumers. Despite buoyant stock markets, labor markets and indexes of consumer sentiment, firms are faced with disciplined, conservative consumers demanding discounts. Airfares, car prices, and apparel are all categories that have been seeing price declines for years as consumers refrain from their freewheeling spending habits of the past. This broad-based price pressure from technology and conservative US consumers is illustrated in Figure 3 which shows a diffusion index of consumer prices calculated as the percent of goods and services with rising prices minus the percent with falling prices. Currently the index stands at 27, with 63% of items in the consumer price index seeing increases versus 37% with falling prices. Historically core inflation hasn’t reached the Fed’s 2% goal for core inflation without the diffusion index being closer to 50.
Figure 5 shows the components of the index, and a secular downward trend in price increases and uptrend in price declines likely in part reflecting technological advances is in clear evidence since the late 1980s. The indices nonetheless still display a cyclical pattern with the share of price declines waning as the business cycle matures. That pattern has been in evidence in the current cycle but has been more muted resulting in a lower run rate for core inflation.
Low inflation driven by technological advances isn’t necessarily bad news for consumers of the economy as it allows people to consumer better products at lower prices. What matters for the vibrancy of growth is real purchasing power, or compensation minus inflation. Technology and globalization have also been a headwind to wage growth, however. Figure 6 plots growth in real compensation calculated by taking nominal growth in wages and benefits and subtracting the core inflation rate. Real wage growth rebounded after the Great Recession but has remained fairly low throughout the recovery as low wages have been matched by persistently low wage growth. Lately real compensation growth has been moderating instead of accelerating, perhaps helping explain why consumers remain cautious despite headline numbers on hiring and unemployment that look like boom times by historical standards.
Low inflation is not unique to the US, Figure 7 illustrates that inflation has fallen and become more stable across the developed work and in many emerging countries. At their annual meeting this week, a senior official at the Bank of International Settlements explored the drivers of inflation and concluded that globalization in labor and product markets and global value chains throughout the production of a wide range of goods and services means that inflation has become a far more integrated phenomenon across countries. The good news is that inflation is lower and more stable nearly everywhere and the risk of localized inflation flare ups at cycle peaks is much lower. The bad news is that domestic policies are less effective in fine tuning inflation and economic outcomes. The market may be right in thinking that the Fed will persistently miss its inflation target to the downside and get stuck at lower levels of interest rates than the Fed currently anticipates. In general, monetary policy may be less effective for any given country and more of a collective phenomenon. If this global framework for thinking about inflation is the right one it poses potentially thorny political questions. Central bankers can still play their role in safeguarding financial stability and stepping in with liquidity in crisis situations, but may need to be relied upon less as the guardians of counter cyclical macroeconomic policy as interest rates, like inflation, are more likely to get stuck in much narrower ranges.