A Case for Lower Rates Still Lurks
Innovation could depress inflation pressure, driving the Fed to pursue faster growth
The Federal Reserve has concluded the latest drop doesn’t qualify because it reflects transient, technical factors.
Yet many similarly transient, technical factors could be lying in wait as inflation starts to reflect new technology, business models and statistical methods. If that happens, the case for lowering rates could become overwhelming.
So-called core inflation, as measured by the price index of personal-consumption expenditures excluding food and energy, plummeted to 1.6% in March from 2% in December, surprising the Fed and most economists.
Three broad forces usually explain inflation trends. One is spare economic capacity: Higher unemployment and weaker spending put downward pressure on wages and prices. A second is inflation expectations: If people expect prices to always rise 2%, they will set wages and prices accordingly and those expectations becomes self-fulfilling. A third includes random factors such as swings in commodity prices and measurement changes.
Slack hardly seems to explain this latest drop. In the first quarter, growth picked up to a 3.2% annual rate, job growth remained solid and stock markets, after a fourth-quarter swoon, hit new highs. This hardly suggests inflation fell because Fed policy was too tight.
Fed Chairman Jerome Powell on Wednesday blamed the miss on transient factors. Last year’s stock swoon translated into lower fund-management fees, while lower fuel prices dragged down airfares and new statistical methods slashed apparel prices. The first two factors are likely to reverse, and the third won’t be repeated. Thus, the Fed remains confident inflation will return to 2%. Private forecasters see that happening by next year.
The problem with this rationale is that these are only the latest of several such transient, technical surprises, all of which go in the same direction: downward. In 2017, cellphone-plan prices fell sharply because the Bureau of Labor Statistics revamped how it measures the plans’ quality and carriers began offering unlimited data. Prescription-drug prices also plummeted. Indeed, overall health care has become a less persistent source of inflation pressure, which might reflect restraint on government payments and the Food and Drug Administration’s stepped-up generic-drug approvals.
Arguably, these represent positive “supply side” shocks: Businesses and government have found ways to deliver the same, or better, products at a lower price.
They are unlikely to be the last. Spencer Hill, an economist at Goldman Sachs, notes federal statistical agencies are seeking to better measure quality in the price of health care, such as treating specific diseases, which could exercise a large impact given health care’s significant weight in consumer spending.
He also notes the agencies plan to broaden the sources of price data for airfares, gasoline, new vehicles, home telephone service, wireless phones and medical services over the next three years. In principle, that need not raise or lower inflation. Yet in March, the adoption of a new data source led to a sizable drop in clothing prices.
If this simply reflects the statistics catching up with reality, inflation won’t necessarily remain low, so the Fed need not alter its policy. But it might be the early signs of an innovation-driven supply-side upswing, in which innovation leads to less inflation pressure and higher output—as happened during the 1990s dot-com boom.
This is a far more pleasant reason for inflation to drop than plunging demand. Yet the Fed cannot ignore it. If repeated supply-side surprises keep inflation below 2%, expected inflation will also eventually slip. This makes it harder for the Fed to get inflation back to 2%. It might thus need to lower interest rates so that growth speeds up, unemployment falls further and inflation returns to target.