"Times they are a-changin'", as someone once said ..... and maybe the Fed will have to

ref :- "Tepid inflation sparks Federal Reserve rethink" , The Financial Times , International Section

In life, and not just in economics, it's reassuring to be able to rely on some basic principles which one knows to be true .... or at least, one thinks one knows to be true. It can be pretty upsetting therefore when one is forced to realise that those accepted truths no longer hold water, and those of a melodramatic bent might be vulnerable to dark thoughts about the world moving on and leaving them behind. Relax .... things have always evolved from one reality to another , and our understanding has always had to evolve with them. It's just that changing fundamental beliefs doesn't come easy.

Since we are at least vaguely concerned with economics at the most basic level, there is no shortage of examples on that front : Trickle - down economics ? The theory may always have infuriated those on one side of the political divide, but in principle, it seemed sensible to many. The financial crisis and its aftermath demonstrated however that rather than promoting investment in (and creating wealth for) the levels of society below them, too many of those creaming it in at the top were more likely to feather their own nests with tax avoidance schemes and the like. One could argue that the global surge in populist politics since the financial crisis is a direct result of the failure of wealth to "trickle - down" from the elite few to the struggling many.

The "Laffer Curve" -- not entirely unrelated -- is another theory that has gone in and out of fashion. Arthur Laffer is a combative figure and probably as a consequence, his theory has been somewhat over-simplified by many, but it is generally taken to hold that because of the increased levels of economic growth that they foster, LOWER taxes actually result in HIGHER government revenue. Mr Trump plainly subscribes to that view and old Arthur started reappearing in the media quite a lot when the President's tax plans became clearer. But attractive idea though it may be in principle -- who wouldn't want BOTH cheaper taxes AND a government with more money to spend ? -- the broader body of opinion among economists has come to be that the theory is fundamentally, and irredeemably, flawed.

All the talk these days is about inflation ..... or rather, the lack of inflationary pressure when all the perceived economic wisdom would suggest that conditions are bound to trigger price rises. Actually, it's been the talk for a long while .... so long in fact that the US Federal Reserve is being forced to reconsider its approach. That very fact tells us that faith in one of the most widely followed economic theories -- the "Phillips Curve" -- is wearing thin. The Phillips Curve lays out the inverse relationship between rates of unemployment and inflation. Essentially, LOWER rates of unemployment beget higher wages which beget higher consumer demand and HIGHER inflation. Perfectly logical ..... just common sense, one would think. Except that in recent years it hasn't been happening.

No one is certain about why the traditional dynamics behind inflation have changed. US unemployment sits at just 4.0% (and has been lower) .... it was above 10% after the financial crisis. Wages are rising at more than 3.0%. But the Fed's preferred measure of inflation -- core (ex-food and energy) Personal Consumption Expenditure (PCE) is once more below 2.0% , the Fed's target rate. Take your pick of reasons just why inflation rates remain stubbornly low when growth, employment and wages are strong : demographics (ageing populations etc), flexible work practices, automation .... or maybe more tangible fundamentals like the possibility of a marked slowdown in China and it's knock-on effect on commodity prices, or low crude oil prices.

Whatever the reasons, they are certainly exercising minds at the Fed. Chairman Jay Powell understandably pointed to worries about slowing global growth and its possible effects on the US economy when he put the brakes on the course of Fed monetary tightening (Europe, China, Brexit etc). But word has it that Fed officials are equally concerned about the dampening effects of further rate rises on an inflation rate that is already too low and not performing as might have been expected. Presumably, they're also particularly concerned with a University of Michigan study that says that not only is inflation low but that people expected the lowest inflation in fifty years over the next few years. Expectations of low or no inflation are BAD news for growth -- they discourage companies from infrastructure investment and at the same time discourage consumers from spending if they don't believe prices are going to rise significantly.

The Fed has started the process of re-examining how it does things and is holding a conference in June, at which they will have to consider whether they need to make some significant changes to their current policy with regard to inflation. At a time when perceptions of what is the neutral rate of interest -- the rate which neither boosts the economy or holds it back -- are low (and falling), what new options are open to the Fed ? They could simply target a higher rate of inflation, but that would be a political minefield and officials have reasserted that whatever modifications are made the underlying 2% target remains intact.

The idea of averaging out policy is getting some airtime .... in other words, if the inflation rate has spent some time below target (and it certainly has), then the Fed should allow for a period of above target-inflation that would average out the rate at 2% over a period of years. One can see the logic, but one can also foresee problems .... political ones as much as anything. The Fed's dual mandate is to foster economic conditions that achieve both stable prices and maximum sustainable employment. Comfortably marrying the brief of "stable prices" with a monetary policy that allows for a moving rate of inflation might be a tricky thing to sell in Congress, whatever its merits.

The Fed has much to ponder , and in their deliberations, we may get to hear whether they believe that the Phillips Curve is past its sell-by date, or just lying dormant for a while. For the sake of those for whom change comes hard, we hope it's the latter.

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