By Paul Kiernan
One reason the Federal Reserve is likely to cut interest rates this week is that inflation is running below its 2% target. New research shows why getting it higher has proved so difficult: many of the prices consumers pay don't respond to the strength or weakness of the economy.
For decades, mainstream economists have seen inflation as determined by slack -- that is, spare capacity -- in labor markets and the broader economy. Too much slack should cause lower inflation; too little should drive up prices. This is captured in the Phillips curve, which shows an inverse relationship between unemployment and inflation.
Recent studies have shown prices in some sectors -- such as housing -- do indeed rise faster when growth is in full swing, unemployment low and markets frothy. But a large chunk of the economy, from health care to durable goods, appears insensitive to rising or falling demand.
A paper published last month by economists James Stock of Harvard University and Mark Watson of Princeton University found prices accounting for nearly half of the Fed's preferred inflation gauge, the personal-consumption-expenditures price index, don't respond to changes in economic activity. In 2017 economists at the Federal Reserve Bank of San Francisco found such "acyclical" goods and services made up a whopping 58% of that index.
The Fed influences inflation by lowering rates to spur demand or raising them to curb it. The new research suggests that to lift overall inflation the Fed may have to stimulate larger price increases in sectors where the Phillips curve still exists to compensate for subdued inflation in those where it doesn't.
Lately, it's been a losing battle.
The cyclically sensitive components of core inflation, which excludes food and energy, have accelerated to 2.33% in the 12 months through May from 0.41% in mid-2010, according to the San Francisco Fed, just as falling unemployment would predict. But that has been offset by falling inflation in acyclical categories -- such as health care, financial services and most goods -- which has slowed to 1.04% from 2.26% in the same period.
Take college textbooks, for instance. For more than three decades, their prices rose faster than overall inflation. They only stopped rising in 2017, a few years after Rice University engineering professor Richard Baraniuk launched a philanthropically-backed initiative offering more than 40 textbooks, ranging from pre-algebra to microeconomics, free over the internet.
If "half of the students are now using a free book, that cuts the average price of the book," Mr. Baraniuk said. "The publishers have had to lower their prices dramatically in order to compete."
Disruptive technologies, government policies and global trade have had similar effects in other markets.
Federal policies such as restraint on Medicare and Medicaid payments to hospitals and doctors and increased approvals of generic drugs have ended a decadeslong trend of rapid health-care inflation.
Growth in the power and speed of computer processors has pushed down prices for most electronics and slowed inflation in services like telecommunications and photo processing. The fracking revolution, enabled by sensors and software that allow energy companies to better locate hydrocarbons, has kept oil and natural-gas prices in check throughout the expansion.
Global factors may also play a bigger role than traditional inflation models assume. As emerging markets like China have expanded their share of the world economy, they influence commodity prices more , according to Massachusetts Institute of Technology economist Kristin Forbes. Her study also says transnational supply chains have more closely linked firms' pricing to global demand and slack.
"So even though we're beyond full employment, you might not expect to see that really spill over very much into oil prices or internationally determined prices," Mr. Stock said.
This all matters for the Fed because its policies work primarily via the domestic business cycle. In the 1980s, former Fed Chairman Paul Volcker crushed double-digit inflation by raising interest rates until the economy fell into recession and demand withered.
The U.S. is now in its longest expansion on record and unemployment is near a half-century low, yet inflation, at 1.5% in May, remains stuck below the Fed's 2% target.
Fed policy makers fear if consumers and businesses expect such low inflation to persist, they may adjust their own price and wage-setting behavior accordingly. That could cause low inflation to become entrenched, a vicious cycle economists call "Japanification."
"That road is hard to get off of," Fed Chairman Jerome Powell told Congress on this month. "So I think it's quite important that we...fight to keep inflation up to 2% and use our tools to achieve that."
If the Fed lowers interest rates this week -- and by doing so only pushes cyclically sensitive prices higher -- it risks hurting low-income Americans. Housing and groceries, two categories that Messrs. Stock and Watson found most responsive to slack, make up 50% of the poorest 20% of households' spending, compared with 36% for the richest 20%.
And some policy makers acknowledge interest rates alone may have less sway over inflation than they once thought. Dallas Fed President Robert Kaplan has said structural factors like technology and globalization are muting the effects on inflation of cyclical factors like tight labor markets. The Fed, he told reporters July 16, does "impact the cyclical elements of inflation, but the structural is a powerful force."
Write to Paul Kiernan at [email protected]