A low trend in inflation suggests the Federal Reserve may be less aggressive in raising short-term interest rates in the months ahead, says Scott J. Brown, Ph.D., Chief Economist.
In the Great Inflation of the 1970s and early 1980s, oil price shocks boosted inflation expectations and quickly spread to wages, which were passed along in the form of higher consumer prices. It took a major recession in the early 1980s to begin reducing inflation expectations, and the Federal Reserve (Fed) worked hard to lower inflation into the 1990s and 2000s.
While the Fed has an official 2% target for inflation (as measured by the Personal Consumption Expenditure Price Index), market participants have begun to see that as a ceiling, rather than a target. If that’s the case, inflation expectations ought to be somewhat below 2%. To counter this perception, officials are expected to indicate a tolerance for inflation somewhat above the 2% goal.
Inflation is driven by a combination of expectations and a measure of the output gap. This gap can be a measure of excess capacity, such as the difference between actual and potential gross domestic product, or a measure of resource utilization, such as the unemployment rate.
Many Fed officials believe that we are close to full employment – meaning that a further decline in the unemployment rate will result in higher wage inflation, which will be passed along in the form of higher consumer prices. The labor market is the widest channel for inflation pressure, but wage inflation has remained surprisingly moderate given the low unemployment rate.
This may reflect fundamental changes in the transmission mechanism of inflation. For example, union membership is a fraction of what it was in previous decades, leaving workers with less bargaining power. Also, a greater concentration of large firms and the increased use of the internet have increased the bargaining power of those purchasing labor.
Fed officials believe that a portion of the low inflation trend is due to transitory effects in a number of components, such as March’s sharp drop in prices for wireless telecom services. However, they are aware that inflation pressures may not build as much as they have in the past. Excluding food and energy, consumer goods have exhibited a mild, steady deflationary trend over the past five years. That likely reflects an impact from global competition.
No doubt, the internet has become an increasing force in retail. Early on, the experience echoed brick-and-mortar shopping. That is, shoppers were less motivated by low prices and more by their comfort level with the online store. Currently, online shopping appears more competitive, adding downward pressure to inflation.
Services account for the majority of consumer spending, with shelter as the largest component. For homeowners, a house serves two functions: an asset and a service (shelter). However, the Bureau of Labor Statistics seeks to measure inflation in the service, not the asset. So it looks at the rental equivalent (i.e., how much it would cost to rent your home). Rents have outpaced overall inflation in recent years, but we’ve seen some moderation this year.
For monetary policymaking, officials generally have an open mind about whether inflation is on a permanently lower track. More data will tell, and the Fed is preparing a number of strategies to lift inflation if needed.
We can expect the Fed to work toward moving inflation toward the 2% target over the next several quarters. More importantly, the demographic shift implies low long-term interest rates in the years ahead.
All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates, Inc. and are subject to change. There is no assurance any estimates will be met.