JACKSON HOLE, Wyo.””Central bankers aren’t sure they understand how inflation works anymore.
Inflation didn’t fall as much as many expected during the financial crisis, when the economy faltered and unemployment soared. It hasn’t bounced back as they predicted when the economy recovered and unemployment fell.
The conundrum challenges much of what central bankers thought they understood about the world, as well as their ability to do their job. How will they know when to raise or lower interest rates if they’re unsure what causes consumer prices to rise and fall?
“There is definitely less confidence, a lot less confidence” about how inflation works,James Bullard, President of the Federal Reserve Bank of St. Louis, said in an interview here Friday.
The mysterious path of inflation during the crisis and post-crisis era is the main topic at the Federal Reserve Bank of Kansas City’s annual economic symposium here, where Fed officials, academics and global central bankers gather every August to discuss economic issues.
Inflation dynamics are more than an academic issue. Fed officials are considering whether to raise short-term interest rates from near zero, where they have been since December 2008. The Fed’s main sticking point is that inflation has run below its 2% target for 39 straight months. Inflation is lower than central bank objectives throughout the developed world, despite exceptionally low interest rates and other extraordinary measures aimed at driving it higher.
Before raising rates, Fed officials want to be confident inflation will rise to 2%. They have a theory it will. Unemployment is falling””reaching 5.3% in July””and slack in the economy appears to be diminishing. As supplies of labor and productive capacity become more constrained, officials believe wages and prices will rise.
So far, however, there are few indications that’s happening. The Commerce Department reported Friday that U.S. consumer prices rose 0.3% in July from a year earlier, well below the Fed’s goal. Stripping out volatile food and energy categories, officially measured inflation also runs below 2%.
The economy’s performance has “really challenged” the notion of a strong link between unemployment and inflation, Mr. Bullard said on the sidelines of the conference. The existence of such a link was also challenged in the 1970s, an era of high inflation and high unemployment.
Fortunately, there another nominal variable that still does track the business cycle very closely:
PS. I have a new article on Milton Friedman and the euro, published in Reason magazine. (Subscribers only, but why wouldn’t you already be a subscriber?)