Central Bankers Rethink Views on Inflation

Symposium reexamines forces that impacted consumer prices during the financial crisis

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.

“The inflation process has not been responding as much as many have expected to the cycle of the economy,” said Athanasios Orphanides, former governor of the Central Bank of Cyprus and a longtime Fed staff economist who now is a professor at MIT’s Sloan School of Management, in an interview. As a result, he said, the Fed “should be a little more uncertain about forecasting inflation than it was.”

One paper presented at the conference here shows how economists are rethinking basic notions about how inflation behaves. Economists typically expect firms to cut or hold down prices in a downturn to keep customers. Simon Gilchrist, a Boston University professor, and Egon Zakrajsek, a Fed board economist, found some firms behave much differently in a financial crisis. When cash is constrained and credit drying up, financially stretched firms instead tend to raise prices to get more cash on hand right away, even if it means losing customers in the long-run, they found.

“Firms behave oddly in a crisis,” Mr. Gilchrist said here during a panel discussion of his paper.

Other trends are challenging the Fed’s inflation forecast, including the decline in oil prices and the rising value of the U.S. dollar against other currencies. In theory a strong currency should put downward pressure on imported prices and inflation. Another conference paper found relatively little pass-through from movements in the dollar to U.S. import prices and domestic inflation. However exchange rate effects on inflation can be strong in other economies.

Today’s uncertainty is a turnabout in a community that gave itself credit for figuring out and taming inflation after bringing it down sharply from double-digit rates in the 1970s.

The Fed’s thinking about inflation forces has changed before. For a while in the 1980s the central bank focused on managing the growth of the supply of money in the banking system. One view was that the purchasing power of dollars was closely connected to the supply of dollars in the economy. The Fed gave up on this approach in the 1990s when links between measures of money supply and measured consumer prices seemed disconnected.

Since then, central banks moved toward setting inflation targets and trying to reach them by adjusting interest rates, often in response to the amount of slack in the economy, as shown in unemployment rates and other measures.

Fed officials had grown highly confident right up to the financial crisis that they could manage inflation. In 2006, then-Federal Reserve Bank of San Francisco President Janet Yellen said the Fed had “earned its credibility: It has a long track record of delivering low and stable inflation."

Two years later, Ms. Yellen said that different forces contributed to U.S. inflation’s decline in the 1980s and 1990s, but much of the credit should go to Fed policy—and the public’s trust that the Fed had both the ability and will to control inflation.

Credibility and trust today are a centerpiece of the Fed’s thinking on how to manage inflation. Economists believe that inflation in the present is driven importantly by the expectations that households and businesses have for inflation in the future. When expectations are anchored, they believe, inflation will remain stable. If expectations shift up or down, actual inflation could follow.

Here, too, the Fed is getting mixed messages. Low yields on government bonds suggest investors expect very low inflation well into the future. Surveys of households and businesses, on the other hand, have been stable since the crisis.

If bond yields are right and the Fed is losing the public’s trust that it can return inflation to 2%, it might become a self-fulfilling prophecy.