The Fed’s low inflation mandate: Not firing on all cylinders

Low inflation

The Cleveland Fed President Sandra Pianalto, a voting member of the Fed’s monetary policy panel who is stepping down at the end of May, said, “Turning to inflation, we are falling short of our 2% objective. The main inflation gauge we watch at the FOMC—the PCE Price Index—has hovered around only 1.1% over the past year.”

Low inflation might sound like good news, but today, it is also a sign of an economy that is not “firing on all cylinders.”

Will the 1949 history be repeated?

After great depression of 1930s, the U.S. encountered many brief periods of deflation including the one in the period from mid 1949 to mid 1950, then from September 1954 to August 1955, and the most recent, one of the shortest-lived eight-month period deflation, in 2009. Deflation is a period in which prices as measured by consumer price index (or CPI) indicator fall steadily over a few quarters. Typically, periods of deflation are associated with downturns, which correspond to recession in the economy.

Having said that, with the U.S. inflation at persistently low levels of 1.1% at present—a sharp decline from the 2.9% in February 2012 and nearly 2.0% over the same period in 2013—Pianalto said, “The big risk is that persistently low inflation could tip into deflation.”

What is the real threat?

In general, deflation is bad for economy; however, in order to fully understand the effect of deflation on economic output, it is important to differentiate the concept of a “real” value from a “nominal” value. A nominal value refers to a value of wages, incomes, or interest rates at current prices. An increase in a nominal value over time partly reflects the rate of inflation. In comparison, a real value holds the actual purchasing power constant over time.

Since wages are set in nominal terms, when unemployment rises under the deflationary conditions, the wages of those workers that remain employed tend to stay the same or grow at a slower rate than before rather than falling with the decrease in demand for labor. This is known as “wage stickiness.” Since the apparent downward revision of the wages can only be done with difficulty and under pressure, the real value of the wages tends to increase if corporations are unable to reduce nominal value.

On the contrary, if businessess are able to reduce the nominal wages instantaneously as a reaction to deflation, then consumers see a decline in the income, which impacts their ability to meet the financial obligations.

During the recent period of deflation in 2009, many large corporations as reflected in the SPDR S&P 500 ETF Trust (SPY), with top holdings in General Electric Company (GE) and Wells Fargo & Company (WFC), other funds such as the iShares Core S&P 500 ETF (IVV), the Dow Jones industrial average (DJI), and the iShares S&P 100 ETF (OEF) experienced a squeeze in their profits, which forced companies to trim payrolls. This increased the country’s unemployment level.

Is that why thecurrent monetary policy remains accommodative? Read on to know Pianalto’s view on the current monetary policy.