In search of the elusive inflation surge

US bond yields began to settle down last week when Fed Chair Janet Yellen stated in her Congressional testimony that the neutral rate for Fed Funds is roughly the inflation rate, which is much lower than market expectations. In addition, she allowed that the Fed is likely to re-evaluate its tightening path in light of tame inflation figures.

Even Fed Governor Lael Brainard, whose Fedspeak had recently taken on a more hawkish tone lately, sounded dovish in a speech last week:

Once that [normalization] process begins, I will want to assess the inflation process closely before making a determination on further adjustments to the federal funds rate in light of the recent softness in core PCE (personal consumption expenditures) inflation...I will want to monitor inflation developments carefully, and to move cautiously on further increases in the federal funds rate, so as to help guide inflation back up around our symmetric target.

The June CPI print came in below expectations, which reinforced the view that low inflation releases may prompt a shallower path for rate hikes in 2017 and 2018. Brainard stated on Thursday, before the CPI release, "I don’t think anybody can give a fully satisfactory answer to why we’re seeing the inflation trajectory that we see today."

In the past, we have seen inflationary surges whenever the unemployment rate falls substantially below 5%. The graph below depicts the unemployment rate (blue line, with the zero level set at 5%), with CPI (red line). The rise in inflation has been quite tame by historical standards, which is creating a dilemma for policy makers.

The Fed's underlying model of inflation is the Phillips Curve, which posits a trade-off between inflation and unemployment. As the chart from this Money and Banking primer shows, the inverse relationship between inflation and unemployment has been flattening since 2000. Falling unemployment should drive up wages, which is the price of labor, and put upward pressure on inflation. This time, the wage and inflation response has been muted.

Questions are being asked at the Fed. Is the Phillips Curve broken? Why aren't wages rising?

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