'Deflationary bias' may afflict US economy, Fed paper finds

[WASHINGTON] The US economy may be saddled with a "deflationary bias" after the last recession that makes it harder for the Federal Reserve to achieve its 2 per cent inflation goal, according to research published this month by the central bank.

Economists Timothy Hills, Taisuke Nakata and Sebastian Schmidt argue that the bias stems from a recognition by companies that the Fed has limited ability to spur the economy when interest rates are low.

That in turn prompts firms to reduce expectations of future costs, affecting what they decide to charge for their products and services.

"Our result provides a cautionary tale for policy makers aiming to raise inflation from currently low levels," the economists wrote in a paper and an accompanying note. "Achieving the inflation target may be more difficult now than before the Great Recession."

Inflation stood at 0.6 per cent in December and has been below the Fed's 2 per cent target for about 3 1/2 years, according to the personal consumption expenditures price index. Policy makers will get another look at cost pressures Friday with the release of a different inflation gauge, the consumer price index.

Fed Chair Janet Yellen and her colleagues have said they expect price gains to gradually move up to their goal as the transitory forces holding them down - namely, a strong dollar and weak oil prices - fade away.

The research by Hills, Nakata and Schmidt calls that expectation into question. In their computer model, inflation settles below the Fed's goal, with the shortfall from 2 per cent coming in at around a quarter per centage point in the baseline simulation.

Hills is an aspiring PhD student at New York University. Nakata is a senior economist with the Fed in Washington. Schmidt works at the European Central Bank in Frankfurt. Publication of the research by the central bank does not indicate that the Fed's board agrees with its conclusions.

To try to offset the deflationary bias, the authors suggest the Fed should place more emphasis on lifting inflation than on stabilizing output. That would imply allowing unemployment to fall below its long-run natural rate.

The central bank could also raise its inflation target from 2 per cent to help increase expectations of future price increases, the researchers said.

At the core of the paper is an assumption that the zero lower bound on interest rates constrains the Fed's ability to promote faster economic growth and higher inflation. It is that constraint - and the likelihood that the central bank will encounter it more frequently in the future - that prompts companies to lower their inflation expectations.

However, even if the Fed pushed rates below zero to a negative half per centage point, the model finds that inflation would still fall short of the central bank's goal, albeit not by as much as otherwise.

The Fed raised the target interest rate in December after holding it near zero for six years.

"Even after liftoff, the effective lower bound constraint can have enduring adverse effects on inflation through its effects on expectations," Hills, Nakata and Schmidt said.

BLOOMBERG