Lack of Inflation - The Federal Reserve's Latest Concern

A recent speech given in Tokyo by St. Louis Federal Reserve Bank President, James Bullard, looks at one of the great concerns facing the Federal Reserve, the lack of inflationary pressures in the U.S. economy.  You may ask, why would this be a problem?  After all, wouldn't it be great if the price of goods and services remained steady or even declined?  In the world of central banking, any signs that prices could drop is considered extremely dangerous because of the impact of dropping demand on the economy.

Let's look at deflation for a moment.  In our inflationary world, we've grown accustomed to purchasing goods and services when we want them because, in our reality, the price of the good or service is likely to rise in the future so there is no need to postpone our purchase.  In a deflationary world, there is motivation to postpone purchasing a good or service since the price is likely to drop in the future.  This lack of immediacy means that demand drops along with prices, slowing down economic growth.  As well, inflation helps reduce debt because debt is paid with future dollars that are cheaper, in other words, the debt is "inflated away".  In a deflationary environment, the opposite is true; debt becomes more expensive in the future, a scenario that sends shudders through the hallowed halls of governments and businesses around the globe.

In James Bullard's latest speech, he looks at recent developments in inflation.  It is particularly interesting that he gave this speech in Japan, a nation that has suffered from a prolonged period of ultra-low and even negative inflation (deflation) as shown on this graphic:

Despite the Bank of Japan's best efforts, they have simply been unable to prod the Japanese economy back into an inflationary pattern.

Now, let's get back to the topic of this posting; James Bullard's view on inflation in the United States.  Here is a graphic from his presentation showing how the expectation of inflation has weakened substantially since the beginning of 2017:

Here is a graphic showing how several measures of inflation (measured in basis points) have dropped since December 2016:

In general and historically speaking, when unemployment is dropping, inflationary pressures increase  because businesses must compete for workers by raising wages, a relationship that is expressed in the Phillips curve.  These higher costs are then passed along to consumers in the form of higher prices.  Here is a graph showing the relationship between the year-over-year change in the core PCE inflation versus the civilian unemployment rate:

Mr. Bullard notes that the unemployment rate hit a low of 4.3 percent in May 2017, a level that would normally cause inflationary pressures.  He also speculates that the current low unemployment rate is unlikely to spark inflationary pressures because a recent study by Olivier Blanchard suggests that:

1.) Inflationary expectations...have become steadily more anchored, leading to a relation between the unemployment rate and the level of inflation rather than the change in inflation.

2.) The effect of the unemployment rate on inflation given expected inflation has substantially declined since the 1980s.

Rather than being tied to the unemployment rate, inflation now depends on long-term expected inflation rather than past inflation and long-term expected inflation now depends little on past inflation.  As well, when looking at the influence of unemployment on inflation, as the level of inflation has decreased over the past three decades, wages and prices have changed less often which leads to a smaller response of inflation to labor market conditions. 

From Mr. Bullard's presentation, here is a graphic showing the estimated influence of various levels of unemployment on inflation:

As you can see, even a substantial drop in unemployment is expected to have little impact on inflation.

Here is a graph showing how the United States economy has fallen well below the 2 percent inflation target set by the Federal Reserve since 2012:

As you can see, the current price level is 4.6 percent below the Fed's preferred inflation pathway.

  

In comparison, here's what happened to Japan's inflation:

While the U.S. economy has not suffered from low inflation/deflation to the same degree as Japan's economy, the trend is, in Mr. Bullard's terminology, "worrisome" just as Japan's deflationary worries began in the mid to late 1990s.

In closing, Mr. Bullard notes that the current low unemployment readings are "probably not an indicator of meaningfully higher inflation over the forecast horizon", an issue that could well prove to be a problem for the world's most influential central bank.  While the U.S. economy is not yet experiencing the deflationary nightmare that has been and is still being experienced by the Bank of Japan, it certainly looks like it is heading in a direction that is unpalatable to the Federal Reserve.