One reason for a Fed cut: Powell now fears too-low inflation

WASHINGTON — In a shift from just a few months ago, Federal Reserve Chairman Jerome Powell is worried that too-low inflation could persist for a while — and undercut the U.S. economy.

Powell’s concern is a key reason why the Fed will likely cut short-term interest rates late this month for the first time in a decade: A rate cut — and especially if it’s followed by others — could help lift inflation closer to the Fed’s target level.

The chairman’s newly expressed worries about chronically low inflation reflect another sea change at the Fed: Powell and other officials seem to have jettisoned a long-standing economic rule of thumb that a long streak of low unemployment will inevitably raise inflation too high.

The U.S. unemployment rate has remained under 5% for roughly three years. And yet annual inflation has consistently failed to reach the Fed’s 2% target.

All of which suggests that the Fed is now prepared to keep borrowing costs low for households and businesses indefinitely — even if the job market and the economy keep growing steadily. It’s a prospect that has delighted investors, who have lifted stock indexes to record highs.

“The connection between the level of unemployment and inflation was very strong if you go back 50 years, and it’s gotten weaker and weaker and weaker to the point where it’s a faint heartbeat,” Powell testified on Capitol Hill this week in response to questions from Rep. Alexandria Ocasio-Cortez, a New York Democrat. “We really have learned that the economy can sustain much lower unemployment than we thought without troubling levels of inflation.”

Kathy Bostjancic, an economist at Oxford Economics, a consulting firm, said Powell’s comments marked a sharp turnaround from last year. The Fed had justified its four rate hikes in 2018 in part by arguing that robust hiring would eventually ignite inflation.

“There’s been a big shift in their thinking,” Bostjancic said. “The Fed’s been slow to this idea.”

Typically in the past, when unemployment has fallen very low — such as to the current 3.7% — employers are compelled to offer higher pay to attract and keep workers. These employers, in turn, raise prices to offset the cost of their higher wages.

Yet that dynamic, which economists call the “Phillips Curve,” has yet to kick in during the decade-long expansion. Consumer inflation in June, for example, was up just 1.6% in June compared with 12 months earlier, below the Fed’s target.

Most Americans, of course, prefer low prices. But the Fed has reasons to worry when inflation stays consistently below its target level. Their biggest concern is that when businesses and consumers expect ultra-low inflation to remain in place, they factor it into decisions, such as how much they’re willing to spend or raise pay. Why spend or pay more now if prices aren’t likely to rise and might even fall?

Once such low expectations become entrenched, Powell warned in congressional testimony Wednesday, they’re difficult to dislodge. Central banks in Japan and Europe have cut their interest rates into negative territory — meaning that holders of government bonds actually lose money — in desperate efforts to accelerate growth and prices.

“You don’t want to get behind the curve and let inflation drop below 2%,” Powell said Wednesday before the Senate Banking Committee, the second of two days of testimony.

Yet according to the Fed’s preferred inflation gauge, it has been below 2% for nearly the entire seven years since the central bank chose that target.

As recently as a May 1 news conference , Powell had characterized lower inflation since the start of the year as merely “transitory,” blaming trends such as a drop in clothing prices. But in his congressional testimony this week, he acknowledged “a risk that weak inflation will be even more persistent than we anticipate.”


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