Close Close
Popular Financial Topics Discover relevant content from across the suite of ALM legal publications From the Industry More content from ThinkAdvisor and select sponsors Investment Advisor Issue Gallery Read digital editions of Investment Advisor Magazine Tax Facts Get clear, current, and reliable answers to pressing tax questions
Luminaries Awards

Portfolio > Economy & Markets

'Deflationary bias’ may afflict U.S. economy, Fed paper says

Your article was successfully shared with the contacts you provided.

(Bloomberg) — The U.S. economy may be saddled with a “deflationary bias” after the last recession that makes achieving the Federal Reserve’s 2 percent inflation goal harder, according to research published this month by the central bank.

Economists Timothy Hills, Taisuke Nakata and Sebastian Schmidt argue the bias stems from a recognition by companies that the Fed has limited ability to spur the economy when interest rates are low. That in turn prompts firms to reduce expectations of future costs, affecting what they decide to charge for their products and services.

“Our result provides a cautionary tale for policy makers aiming to raise inflation from currently low levels,” the economists wrote in a paper and an accompanying note. “Achieving the inflation target may be more difficult now than before the Great Recession.”

Inflation stood at 0.6 percent in December and has been below the Fed’s 2 percent goal for about 3 1/2 years, according to the personal consumption expenditures price index targeted by the central bank.

A separate gauge of inflation, the consumer-price index, put it at 1.4 percent in JanuaryLabor Department data released Friday showed. Excluding food and energy costs, so-called core prices were up 2.2 percent from a year earlier. The Fed targets the PCE index rather than the CPI because it believes the former is a better measure of actual inflation.

Fed Chair Janet Yellen and her colleagues have said they expect price gains to gradually move up to their goal as the transitory forces holding them down — namely, a strong dollar and weak oil prices — fade away.

Below Target

The research by Hills, Nakata and Schmidt calls that expectation into question. In their computer model, inflation settles below the Fed’s goal, with the shortfall from 2 percent coming in at around a quarter percentage point in the baseline simulation.

Hills is an aspiring Ph.D. student at New York University. Nakata is a senior economist with the Fed in Washington. Schmidt works at the European Central Bank in Frankfurt. Publication of the research by the central bank does not indicate that the Fed’s board agrees with its conclusions.

To try to offset the deflationary bias, the authors suggest the Fed should place more emphasis on lifting inflation than on stabilizing output. That would imply allowing unemployment to fall below its long-run natural rate.

The central bank could also raise its inflation target from 2 percent to help increase expectations of future price increases, the researchers said.

At the core of the paper is an assumption that the zero lower bound on interest rates constrains the Fed’s ability to promote faster economic growth and higher inflation. It is that constraint — and the likelihood that the central bank will encounter it more frequently in the future — that prompts companies to lower their inflation expectations.

However, even if the Fed pushed rates below zero to a negative half percentage point, the model finds that inflation would still fall short of the central bank’s goal, albeit not by as much as otherwise.

The Fed raised the target interest rate in December after holding it near zero for six years.

“Even after liftoff, the effective lower bound constraint can have enduring adverse effects on inflation through its effects on expectations,” Hills, Nakata and Schmidt said.

See also:

Forget the Great Recession — welcome to the ‘Great Repricing’

Yellen signals rate path hinges on whether turmoil persists

5 questions for Janet Yellen

The probability of negative U.S. rates is on the rise


© 2024 ALM Global, LLC, All Rights Reserved. Request academic re-use from All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.