The Fed's View Of Inflation: 3 Ideas That Drove Their Decision Not To Tighten

The Fed’s decision not to raise interest rates hinges critically on its view of inflation. The only reason to raise rates—ever—is to deal with inflation. Here are three things the Fed knows about inflation:

1. Times Lags Are Critical In the Inflation Process.

The Federal Reserve Bank of San Francisco used to have some economics games in its lobby. The monetary policy game told me that I was fired as Fed chairman the first time I tried playing it. On the second time, however, I figured out that the game had a long time lag built in between current economic conditions and changes in the inflation rate. One had to move early in an economic expansion to prevent the need for a major correction later on. This game was based on economic theory behind inflation, at least as of the early 1980s. The implication is that low current inflation is not what the Fed is watching; instead, they are looking at future inflation.

2. The Fed Expects Low Inflation for Some Time.

The Fed released economic projections by the members of the Federal Reserve Board and the 12 regional presidents. The inflation forecasts have been lowered. The median forecast of inflation gets up to two percent, the Fed’s target, in 2018. The time lag between action and inflation response is long, but it’s not three years long.

3. Inflation Models Are Not Working Well Now

The Fed’s decision-makers have been surprised by low inflation numbers. The unemployment rate has  dropped from about nine percent in 2011 to just over five percent most recently. The gap in GDP between where we are and our potential output has dropped from 5.9 percent to 3.1 percent in four years. This strength should have pushed up inflation, but the Fed’s preferred measure has declined since late 2011, down from two percent to 1.3 percent.

Two monetary policy experts say

the models we have simply aren’t very good at forecasting inflation – at least not to the precision we would need to distinguish a change of trend inflation of one-half of one percentage point over the next two years. And, what was challenging a decade ago has gotten more difficult since then. 

Going forward, the Fed is nervous about the high amount of monetary slack, which it knows should be unwound at some point in the future. Chairwoman Yellen, in her press conference, said that failure to tighten policy could result in so much growth that inflation would have to be dealt with by a very sharp interest rate hike. That could trigger a recession. Better, she said, to have a gradual move in time. I continue to expect that the Fed will raise interest rates by a quarter of a point before the year is up.