Fed’s Daly unravels ‘inflation puzzle’

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Disruptions between monetary policy and the economy help explain the “inflation puzzle we’re facing,” according to Federal Reserve Bank of San Francisco President Mary Daly.

“I feel good about where we are on employment — but a little less so about inflation,” Daly said in a speech in San Francisco Tuesday, according to prepared text released by the Fed.

But, she noted, “in the real world, things crop up that disrupt the simple linkages between monetary policy and the economy … I like to call these things ‘wedges.’ And understanding these wedges goes a long way toward understanding the inflation puzzle we’re facing.”

The labor market is changing, as workers seek “alternative forms of compensation,” which policymakers can’t track. “These alternative forms of payment aren’t being captured in the traditional measures we use to track wages and salaries,” she said. “This creates a wedge between the strong labor market we observe and our available indicators of wage growth, and it mutes the signal we’re receiving about the strength of the economy.”

Additionally, workers find it difficult to bargain or to “push for higher pay, even in very healthy job markets,” which “weakens the link between employment and wage growth.”

And, firms, which face global competition, often can’t pass along rising costs. “All of these wedges are contributing to the situation we have today: a strong economy with a tight labor market — but muted inflation,” said Daly, who is not a voter on the Federal Open Market Committee this year.

The Fed has done a good job, she said, in keeping inflation near 2%, “and the success of its monetary policymaking decisions” is also “weakening the link between economic activity and inflation.” The Fed’s commitment to keep inflation in check “became a well-known and accepted position that people could depend on,” Daly said. “And it ushered in the conditions that dominate today — the era of well-anchored inflation expectations.”

With the public aware that the Fed plans to keep inflation near 2%, “they’re more likely to see inflation fluctuations as temporary, and stop short of building them into contracts like wage and rental agreements. In other words, when the Fed is credible, it’s easier for the economic system to absorb shocks.”

So inflation won’t plummet in a weak economy or skyrocket when the economy is booming. “When the Federal Reserve is doing its job well, the link between economic activity and inflation is weaker — much like we see today,” she said. “This is the essence of the ‘Fed wedge.’”

With inflation having been below the 2% mark for the past seven years, Daly said, there’s a risk of “deflation — or negative inflation,” which “makes it harder for the Fed to adjust interest rates in the face of economic shocks.”

“Inflation consistently below target tugs at inflation expectations,” she added. Inflation expectations have edged lower, she said. “This bears close watching. We need to be vigilant on this front, and work to deliver 2% inflation on a sustained basis. The Federal Reserve’s continued credibility with consumers and businesses depends on it.”

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Monetary policy Mary Daly Federal Reserve Federal Reserve Bank of San Francisco FOMC