Specter of no-inflation world looms over Fed's return to normal

Fri Oct 24, 2014 1:06am EDT
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By Howard Schneider

WASHINGTON (Reuters) - After months of focus on slack in U.S. labor markets, the Federal Reserve faces a new challenge: the possibility that weak inflation may be so firmly entrenched it upends the return to normal monetary policy.

The soft global inflation backdrop, from sliding oil prices to stagnant wages in advanced economies, has triggered debate over whether the Fed and its peers merely need to wait for a slow-motion business cycle to improve, or face a shift in the underlying nature of inflation after the global recession.

That uncertainty has become the Fed's chief concern in recent weeks, likely to shape upcoming policy statements and delay even further the moment when interest rates, pinned near zero for nearly six years, will start rising again.

Investors have already pushed expectations for an initial rate hike back several months to late next year because of a dimmed global outlook. The Fed is expected to take note of recent market turmoil and worsened world conditions at its Oct 28-29 meeting even as it ends the bond-buying program launched to fight the financial crisis.

Yet if the Fed keeps struggling getting inflation back to its 2 percent goal it could prompt a deeper rethinking of its approach. That could involve an even more open-ended commitment to low interest rates, the renewal of asset buying to pump cash into the financial system, or more aggressive language to encourage households and businesses to invest and spend.

Inflation was already acting out of character during the 2007-2009 recession when it fell less than expected. Now, its glacial movement during the recovery suggests something basic may have changed, San Francisco Fed President John Williams told Reuters last week.

"Either it is because inflation is no longer a good judge of (economic) slack or there are some other factors" yet to be understood, he said. "These are things we are trying to understand - what is structural, what is cyclical."

Williams said he still expected that eventually "Economy 101" forces of supply and demand would regain traction, and push up wages and prices around the world.   Continued...

The sun rises to the east of the U.S. Federal Reserve building in Washington, July 31, 2013.  REUTERS/Jonathan Ernst