The U.S. economy has been growing for 96 straight months, its third longest expansion on record, and if this were any previous expansion, the Federal Reserve’s decision on Wednesday would be a no-brainer: It would be time to raise interest rates. The unemployment rate, at 4.3 percent, is at its lowest level since 2001 and job growth has remained strong for this stage of the recovery. Most importantly, the Fed currently has its target rate set at just 0.75-1.00 percent, far below historic levels. After eight years of unusually low interest rates, the conditions appear ripe to bring them back up.
But one critical economic indicator is saying otherwise: inflation. Normally when the economy is humming, inflation starts to rise, but in this case, the Fed’s preferred measure of annual inflation has actually declined for three months in a row, hitting 1.7 percent in April. If you exclude volatile food and energy prices, inflation is even lower, at 1.5 percent. (The Fed’s inflation target is 2 percent.) And on Monday, the New York Federal Reserve reported that consumer inflation expectations had declined as well; expectations for inflation three years from now hit their lowest point since January, 2016.
All of which poses a big problem for the Federal Reserve board as it meets to decide whether to raise the Fed funds rate a quarter point. Traditionally, central banks raise rates as the economy approaches full employment, choking off wage growth before it causes a burst of inflation. But in the U.S., most economists agree that the economy is nearing full employment. Yet, there are no signs of rising inflation; in fact, inflation has been falling the past few months.
What’s going on?
No one knows for sure, but the answer is crucial for millions of U.S. workers—and Trump’s presidency. If the Fed mis-identifies the causes of lower inflation, it could prematurely pump the brakes on a recovery that still hasn’t reached many workers and could imperil Trump’s most important promise to the “forgotten” Americans: that they would finally get a raise.
Here are three theories for why inflation has remained so low:
The economy still is still not at full employment
Even though the unemployment rate is low, there still may be slack in the labor market, holding back any upward pressure on wages and prices. For instance, a broader measure of unemployment—the U-6 measure, which includes part-time people who want a full-time job and people who want a job but aren’t actively looking for one—hit 8.4 percent at the end of May, its lowest level since 2007. But during 2000, it was even lower, below 7 percent—indicating it still has room to go down as the economy improves. Another measure of labor market strength—the percentage of working age Americans employed—also remains below its pre-crisis level.
Most importantly, wage growth in the U.S. continues to be weak. Real hourly earnings grew by 2.5 percent over the past year, a slight improvement over recent months, but still below historical levels. Normally as the job market tightens, workers have more leverage to demand higher wages, but this time wages aren’t going up much. Economists aren’t sure exactly why that is the case—some say it’s a result of slack in the labor market, while others point to weak productivity growth or increased corporate concentration, which gives employers more leverage over pay. But as long as wage growth remains weak, employers won’t need to raise prices.
Joseph Gagnon, an economist at the Peterson Institute for International Economics who has worked on and off at the Fed for decades, said that a further complicating factor was inflation expectations, which have been falling since February. If businesses expect inflation to be low, they may adjust their practices accordingly. For instance, a restaurant may offer its waiters smaller raises, giving them less money to spend at other stores which leads to smaller raises at those establishments—and lower overall inflation. In other words, low inflation expectations can be self-fulfilling.
For the Fed, this could be especially dangerous, as inflation may remain muted even at full employment. Said Gagnon, “You might have to seriously overheat the economy to get them back up.”
Global economic weakness is weighing on the U.S.
Douglas Holtz Eakin, the former director of the Congressional Budget Office and head of the American Action Forum, has a different theory for low inflation: the global economy is holding it down.
The U.S. recovered much quicker from the financial crisis than Europe and many developing nations, including Brazil, Russia and China, which have faced their own economic struggles. Those international headwinds have lessened in 2017, but growth remains weak. That could be holding inflation down not just in those countries but in the United States as well.
As evidence for this, Holtz-Eakin points to the difference in inflation for goods, which can be traded between countries, and services, which largely—though not always—cannot be traded. Think about it this way: A person in Paris cannot get a haircut from a barber in New York, but can purchase a hat from a Brooklyn retailer. Thus, goods exist in a global market, whereas services are more local. Over the past year, prices on goods have risen just 0.3 percent, while they have risen for 2.4 percent for services.
“All roads lead to global trade in goods,” Holtz-Eakin said.
In effect, prices are rising in service industries, which have to compete for a fixed pool of American workers, but prices are barely rising in goods-producing industries, which are able to shift production abroad and take advantage of weak international labor markets. There’s some evidence for this theory in the wage data as well: average hourly earnings rose 2.1 percent for workers in goods-producing industries over the last year versus 2.6 percent for service workers.
Cheap smartphone plans are to blame
Could competition among cell phone providers be holding down inflation? It appears so—but only quite recently.
An ongoing price war among wireless carriers has led to big benefits for consumers, especially unlimited data plans—and prices are dropping fast. In March alone, prices for cell phone plans fell 7 percent; they have declined nearly 13 percent over the past year. Of course, the cell phone wars have been going on for a few years. Why did they just show up in the data recently? Because in January, the government changed how it accounted for unlimited data plans in inflation statistics, resulting in a shift downward. This statistical quirk is likely to be a one-time occurrence, but it helps to explain the recent decline in inflation, and Fed officials are taking it into account.
UNDERSTANDING WHY INFLATION is low is especially important as the Fed decides whether to raise the Fed funds rate this week. Most economists expect the central bank to hike its target range by a quarter-point; Fed officials have signaled this in recent speeches, where they have blamed statistical quirks for the recent slowdown in inflation and argued that raising rates is necessary as the economy approaches full employment.
But what if they’re wrong? The real risk with lower inflation is that the Fed will slow growth before the economy is actually near full employment. The truth is that no one really knows how much slack remains in the labor market. Few economists predicted that the unemployment rate would fall this far this quickly—with wage growth barely picking up.
Trump has promised to put millions of discouraged workers back to work. “I call them the forgotten men and women,” he said Monday as the White House kicked off “workforce development week". “But they are not going to be forgotten much longer.” Many economists are skeptical that there are that many workers still on the sidelines–but if they do exist, the power to cajole them back into the labor market lies not with Trump but with the Federal Reserve, which can withhold rate increases and allow wages to rise. The Fed, though, is likely to move in the opposite direction Wednesday and has signaled further rate increases later this year.
If that’s the case, Trump may be unable to fulfill his pledge to put those “forgotten men and women” back to work—and it may not take long for the president to aim his fire at the central bank itself.