High Cost of Low Prices for the Fed

High Cost of Low Prices for the Fed

JUSTIN LAHART

Dec. 23, 2013 12:51 p.m. ET

The Federal Reserve has two things on its wish list for 2014: A better job market and more inflation. It looks likely that it will get the first. The second is less certain.That inflation has been so low this year is a surprise. The economy has expanded about as fast as economists polled by The Wall Street Journal near the beginning of the year had forecast. Job growth has been stronger, and the unemployment rate lower, than anticipated. So, if anything, inflation ought to be higher than was expected.

Instead, it has been lower. The Commerce Department reported Monday that its index of consumer prices excluding food and energy, the “core” measure that the Fed prefers, was up just 1.1% in November from a year earlier. The headline index was up an even scantier 0.9%, as energy prices drifted down. Back toward the start of the year, economists forecast that core inflation would be up 1.8% in the fourth quarter, with the headline up 1.9%.

For the Fed, which wants inflation to go back up to its 2% target, and says it would accept it going temporarily higher, this is worrisome. The lower inflation, the lower overnight interest rates must be to generate enough spending to bring the economy to full employment.

Now inflation is so low that even overnight rates at zero haven’t been adequate to spur growth. That’s why the Fed has had to resort to other measures like its bond-buying programs and, more recently, signaling that it will keep rates low for a long time.

Fed Chairman Ben Bernanke last week made the case that inflation should start moving higher in 2014. Inflation expectations haven’t fallen: Consumers expect more inflation than they have been getting. Economic growth appears to be picking up and wages are rising. But, he added, “inflation cannot be picked up and moved where you want it. It takes…some luck and some good policy.”

Luck might not be in the cards. Job growth is picking up but there is still a substantial amount of slack in the labor market, with many people giving up the search for employment. Some economists believe that a mismatch between the skills that unemployed workers have and the ones companies seek will force firms to boost wages to retain the staff they need, paving the path for higher inflation.

Economists at Bank of America Merrill Lynch aren’t so sure. They point out that unemployment rates remain elevated relative to their levels from 2000 to 2007 across the board. And they also note that of the 30 occupation and industry groups for which the Labor Department tracks compensation, 21 have seen it increase 1.5% to 2.5% over the past year. Of those that remain, just one posted higher growth, while eight are lower.

Beyond the pace of job growth, it may be that the structure of the economy has shifted in a way that inflation will tend to be lower than the Fed’s target. The University of Michigan/Thomson Reuters survey of consumers on Monday showed that people expect inflation to run at 2.7% over the next five years. But the inflation that they will actually accept may be much lower, framed by their experience of the past several years. So companies could struggle to raise prices and remain unwilling to raise wages as a result.

It may even be the case that aging societies like the U.S. simply don’t tend to generate as much inflation as younger ones. Among the 34 countries in the Organization for Economic Cooperation and Development, countries with higher median ages are associated with lower rates of core inflation over the past decade.

All of which raises a discomfiting possibility for the Fed. The days when manipulating short-term interest rates was all it needed to do to push the U.S. economy where it wanted it to go may never be coming back.