The Federal Reserve raised interest rates for the first time in nine years on the expectation of a healthy US economy experiencing 2.2% growth. While the Fed is more than happy with unemployment rate of 5% that is close to estimates of full employment, the inflation rate is 0.2% and far from the Fed target of 2%.
A general belief is that central banks have control over the rate of inflation and as famously put by Milton Friedman inflation is always and everywhere a monetary phenomenon and can be produced only by a more rapid increase in the quantity of money than in output. Hence, for too low inflation central banks can lower interest rates and boost the economy and high inflation could be checked by raising rates.
Noah Smith who is a loud economist recently tweeted: if you think there is some group of humans out there who understands inflation, you’re probably wrong.
Basically, it seems no economic model can explain the inflation below its targeted rate in the US for about 4 years. This is rather surprising as many economists were warning about runaway inflation when Fed quantitative easing program was first put on the table in response to the worst financial crash in modern times.
The inflation puzzle is not limited to US and many developed economies are struggling to materialize the 2% inflation target. Japan is experiencing 0.3% inflation and 1.1% growth rate despite the launch of the biggest QE program and fighting economic slump for about 20 years. The eurozone has annual inflation rate of 0.1% and 1.9% growth in output from a year ago; the UK has minus 0.1% inflation and growth of 2.3% over the same period.
There is still so much to be known with regards to recession times. It seems when recession hits the economy some basic assumptions of macroeconomic theory don’t hold anymore and conventional models become subject of controversy due to significant amount of uncertainty rooted in the people's perception of the economy.
There are some attempts to explain the inflation puzzle such as the idea that low interest rate causes low inflation and deflation in the long run, which will be tested in few years in Japan and approved if Japan slides back into deflation. The Fed action of raising interest rates despite no evidence of rising inflation might indicate a change in officials’ belief about inflation’s behaviour. It is as if the inflation is influenced by the thinking of economic agents who might consider higher cost of borrowing as an indication of future higher prices. If people are expecting higher prices, as the Fed does, they will try to ask for higher prices and wages, helping to push inflation. However, inflation also depends on the behavior of working-age population and if they contribute to boost demand by their spending and push prices higher.
It is a matter of time to see what happens to inflation following the interest rates hike. If inflation reaches its target of 2% as expected by the Fed, then there may not be too much need for macroeconomists to hold their breath. However, if the Fed prediction comes to be wrong again, then economists should ask what if mainstream macroeconomics has it all upside down? There seems to be a genuine need for casting new ideas about the effect of prolonged period of low interest rate.
