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“Since the financial crisis, the relationship between the strength of the economy and inflation trends has differed from previous patterns.”

Dan Sichel

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Why Is Inflation so Low?

Editors Note: This analysis is being published in collaboration with EconoFact, a nonpartisan economic publication that created the following content.

The Issue:

Inflation has averaged just over 1-1/2 percent over the past decade, well below the Federal Reserve’s target of 2 percent. Such low inflation for such an extended stretch is quite unusual given historical economic relationships. With the current unemployment rate near historic lows, the persistent soft readings on inflation pose a puzzle and challenge for economists, financial market participants, policymakers, and the general public who must make decisions based on what they expect inflation to be in the future. Accordingly, much attention has been focused recently on trying to understand why inflation has been so low in recent years.

The Facts:

What this Means:

The evolution of inflation is relevant for all economic actors. However, for policymakers at the Federal Reserve, understanding the sources low inflation is of paramount importance. If the low inflation reflects persistent factors that will restrain inflation for an extended period of time, then the Federal Reserve could reasonably set interest rates at lower levels and would need to be highly attentive to the possibility of declining inflation (particularly in the event of a recession). On the other hand, if the low recent inflation reflects transitory factors that begin to abate and the economy remains reasonably strong, then the Federal Reserve likely would need to set interest rates at higher levels as the usual relationship between unemployment and inflation again becomes evident. Mistakes could be costly, leading either to inflation that falls further below the Federal Reserve’s target or inflation that rises too far above, in which case the Federal Reserve likely would raise rates significantly (possibly enough to cause a recession). Although much interesting economic research has shed light on recent inflation behavior, the Federal Reserve will have to make decisions with imperfect information about these issues.

By EconoFact Network

By Dan Sichel, Wellesley College