Since 2008, when the US Federal Reserve introduced quantitative easing (QE), there has been concern that the stimulus would lead to a surge in inflation. However, core personal inflation has averaged only 1.4 per cent since the recession ended in June 2009 compared with close to 2.1 per cent previously.
Nonetheless, with unemployment falling faster over the past year than most economists expected, inflation worries have emerged again – though this time focused on tightening labour market conditions rather than the liquidity created by QE.
If inflation continues to accelerate, the Fed’s tightening of policy over 2015 and 2016 could be more substantial than currently indicated by its forward guidance. Such concerns have led to claims that the Fed is behind the curve, but we believe its view is justified because of shifts in the importance of the factors that drive inflation.
There seems less of a link between total unemployment and inflation in the current economic cycle
The classic Phillips Curve approach links the unemployment rate to changes in inflation, with the unemployment gap key in forecasting changes in inflation. But since 2008, this relationship has changed: there seems less of a link between total unemployment and inflation in the current economic cycle.
Inflation expectations appear to be playing a bigger role. They have not reacted to the recent decline in the trend rate of inflation. Essentially, expectations have become more anchored, and we believe this is a key reason US inflation has stayed – and will stay – low.
Whatever the reasons, if inflation expectations have become more anchored, then inflation is likely to change only slowly in response to changes in the unemployment rate or external shocks such as spikes in energy prices or sudden changes in the growth of labour productivity.
Most importantly in the current context, the sharp decline in the unemployment rate over the past year is not necessarily a precursor to a sharp rise in inflation in the coming year. For example, a further decline in short-term unemployment may put only modest upward pressure on core inflation.
We expect the unemployment rate to fall further this year, but only modestly as the labour force participation rate stabilises and the growth of the labour force rebounds from the past year’s slowdown. From an average 6.2 per cent in the second quarter, we expect unemployment to be close to 6 per cent in the final quarter while the core personal-consumption price index should show a 1.7 per cent annual increase in the fourth quarter, up from 1.2 per cent a year earlier.
So the likelihood of inflation exceeding the Fed’s 2 per cent target in the medium term is not high. For the same reason that inflation did not fall much over the last few years, it may not rise far in the coming year. If that is the case, the Fed is justified in adopting a cautious approach to lifting short-term interest rates. Our view that it will keep rates on hold until late 2015 is partly based on inflation being contained in the coming year.
This research was first published on 24 July 2014.