J.D. Foster J.D. Foster
Former Senior Vice President, Economic Policy Division, and Former Chief Economist


May 23, 2019


The recent focus on possible nominees to the Federal Reserve, as well as suggestions by President Trump as to how the Fed should execute monetary policy, occasion considering a related topic given too little attention – what exactly determines inflation?

The Fed’s dual mandate is to pursue stable prices and maximum employment (along with low interest rates). As to prices, the Fed interprets its mandate to mean low and stable annual inflation of about 2%. On this, the Fed has been remarkably successful. In 2018, the core Personal Consumption Expenditure index (PCE), a common measure of inflation, rose 1.9%. For the last quarter century the PCE varied in a fairly narrow range from 1.2% to 2.3%.

The stability of inflation over this period is all the more remarkable considering the changes and shocks the economy has withstood over the period. Among the notable changes is the rapid evolution of financial markets and the advances in information technology, while shocks have included the dot-com bubble, a couple wars, China’s accession to the World Trade Organization and subsequent massive trade surpluses, and, of course, the 2008-2009 financial crisis and Great Global Recession.

While critics may harp on inflation coming in a tad below the Fed’s goal, in fact it would seem more appropriate to congratulate the Fed on its performance viz-a-viz inflation for a job reasonably well done.

Except for one little thing – the Fed isn’t sure why its policies are working.

This was brought to light in remarks made in 2016 by then Fed Chair Janet Yellen. Yellen posed four issues on which she thought the economics profession needed to focus, the fourth of which being, “What determines inflation?”

This was an astounding question for the Fed Chair to ask. It’s not as though she hadn’t given the matter some thought. It was all the more remarkable given the Fed’s legion of top economists and demonstrated recent success in keeping inflation very near its target.

It’s not that economists haven’t sought explanations for inflation, or haven’t developed highly sophisticated theories of macroeconomics or monetary theory over a few hundred years. The issue isn’t the effort, but the theoretical results, as Yellen pointed out, are not very satisfactory as guides to policy.

For example, one intuition from any of the variations of the popular Phillips curve is inflation will tend to tick up when the unemployment rate or some other measure of economic slack suggests the economy is at or near full employment. A seemingly reasonable proposition, except the theory so often and obviously fails. The unemployment rate has been below 5% for three years and currently stands at 3.6%, yet inflation remains quite indifferent.

Even if Phillips curves variations showed a rare glimmer of promise, the trouble remains the theory doesn’t say much about the initial rate from which inflation would rise. Some versions attempt to solve the problem by anchoring the model on future inflation expectations, but then don’t tell us much about how those expectations were formed or whether they were roughly correct.

Another approach is to consider a well-accepted relationship whereby nominal interest rates are the sum of (expected) inflation and a real interest rate, commonly assumed to be stable over the medium term. A lovely, simple, intuitive expression, but less of an explanation than a consequence. For example, it implies that if the Fed raises nominal interest rates to counter inflationary pressures, then for the equation to hold inflation must increase, a rather counterintuitive outcome.

One might instead fall back on an older tradition relating the quantity of money and the rate at which it turns over in a period – the velocity – to the price level and the volume of transactions. But given the evolution of payments systems, what constitutes “money,” and what use is this theory if the velocity of money changes unpredictably and may even be in some fundamental manner endogenous to the economy? Like so many models purporting to offer insights into inflation, it’s a lovely equation, but it’s less informative that it appears.

Following the Great Recession the eminent monetary theorist and former Fed Governor Frederic Mishkin observed that Milton Friedman’s adage that “inflation is always and everywhere a monetary phenomenon” still holds true. This is a start. But exactly how monetary policy affects credit markets under various circumstances to produce certain levels of inflation and inflationary expectations remains something of an enigma. Hence, Yellen’s poser.

Perhaps this is all a worry about a non-problem. After all, theory or not, the Fed – along with the European Central Bank, the Bank of England, the Swiss National Bank, and others – seem to have a pretty good handle on inflation, neither holding it too low or goosing it too high. Maybe this is just another of the modern anomalies in economics for which one shouldn’t look the gift horse in the mouth. Among the others: Why very low real interest rates persist, especially in light of very substantial budget deficits that were supposed to drive interest rates higher.

It’s tempting to take such a “why worry, be happy” attitude, but history suggests such happy periods don’t last forever. Far more likely it seems, inflation will someday rise (or worse, fall) far from the Fed’s target, and lacking a credible theory of inflation, the Fed may not know why or what the proper remedy would be other than hiking the Fed Funds rate – which might or might not be the proper and effective response. “What, me worry?” versus “Houston, we have a problem.” I think we should take Janet Yellen’s proposed task seriously.

About the authors

J.D. Foster

J.D. Foster

Dr. J.D. Foster is the former senior vice president, Economic Policy Division, and former chief economist at the U.S. Chamber of Commerce. He explores and explains developments in the U.S. and global economies.