I generally do not hang on every word spoken by Fed speakers, but every so often a speaker does seem to hint strongly on what lies behind a current policy debate. In this case, Vice-Chairman, Richard Clarida delivered a speech that identifies why the Fed’s inflation target seems ever more elusive. He lays the blame squarely on the shoulders of expanding supply when he argues that:

It appears that in 2018 and in the first objective quarter of 2019, the supply side of the economy—employment, participation, and productivity—expanded faster than most forecasters outside and inside the Fed expected. Notwithstanding robust growth in demand over these five quarters, PCE price inflation fell somewhat short of the Fed's 2 percent. [1]

Daily, we are inundated with statistics from the demand side of the economy ----- all the various expenditure components that make GDP ---- while ignoring the supply side. Clarida points out that there have been a number of important developments from the supply side that bear directly on holding down price increases, factors that do not seem to be transitory as we would like to think. He rightly points out that:

• The US unemployment rates can remain at historically low rates without triggering wage inflation; he suggests that unemployment below 4 % can be consistent with no wage pressures; in the past, reaching a high level of employment meant that cost-push inflation was on its way;
•  The growth in the labor force participation among prime-age workers is an important source of additional labor, keeping wages and inflation in check; moreover, this category can continue to grow, thus adding to the country’s potential output;
• There has been a noticeable pickup in the trend productivity growth relative to earlier periods of expansion; the economy is expanding without incurring higher costs of production;
•  The Phillips curve now appears to be very flat, suggesting that there is no longer any strong connection between falling unemployment and inflation; this long-held theory has lost considerable credibility as a predictor of inflation.

The Vice-chairman takes these developments and concludes that “the U.S. economy is in a very good place, with the unemployment rate near a 50-year low, inflationary pressures muted, expected inflation stable, and GDP growth solid and projected to remain so”. In other words, the US should not expect any inflationary pressures originating from the supply side. In fact, quite the opposite seems to be the case as more production can be achieved without incurring higher costs.

But what about demand conditions causing inflation? That seems to be the least of the Fed’s worries as global economic conditions weaken in the midst of China-US trade war.  And, now evidence is starting to mount that US domestic demand is softening and talk of recession enters the discussions regarding the outlook. Given that the supply side is capable of continual expansion and that there are downside risks on the demand side, it is no wonder the Fed is facing the prospect of rate cuts.

[1] At the Economic Club of New York, New York, New York, May 30, 2019