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The Fed Is Flying Blind

The U.S. central bank isn’t sure why inflation is staying so low—but it’s raising rates anyway, risking a recession.                 

The architects of U.S. monetary policy at the Federal Reserve should be happy. They’ve succeeded beyond their own expectations in bringing down the unemployment rate without triggering an outburst of inflation. Stock indexes are near record highs, and interest rates remain low.

But those who set interest rates are in the awkward position of not understanding how things got so good—and are therefore confused about what to do next. “The Fed isn’t run by computers, it’s run by people,” says David Rosenberg, chief strategist at Gluskin Sheff + Associates, an asset management company in Toronto. “Like all of us they have their flaws and their blind spots.”

On June 14, the Federal Open Market Committee voted as expected to raise the federal funds rate a quarter point, to a range of 1 percent to 1.25 percent. It said it expects inflation to rise to its 2 percent target “over the medium term.”

For Fed Chair Janet Yellen and company, the central mystery continues to be why ­inflation remains below 2 percent despite unemployment having dropped to just 4.3 percent in May. Even ex-convicts and high school dropouts are getting job offers—one reason why many economists believe it’s inevitable that wages must rise. “When you have a shortage of supply of something, its price will go up,” says Gad Levanon, chief U.S. economist at the Conference Board, a business-­supported research group.

A tight job market, however, hasn’t translated into inflation. The Fed’s preferred measure of inflation, the personal consumption expenditures price index, rose just 1.7 percent in April from a year earlier. On June 14, as the Fed was meeting, the Bureau of Labor Statistics announced that the Consumer Price Index excluding food and energy rose just 0.1 percent in May, the third surprisingly low reading in three months.

Michael Feroli, the chief U.S. economist at JPMorgan Chase & Co., sympathizes with Yellen’s predicament. He said in an interview before the FOMC meeting that Yellen is relying out of necessity on the Phillips curve, which says that lower unemployment leads to higher inflation. “It’s kind of the best we’ve got” as a descriptor of the economy, he says. Still, Feroli couldn’t resist headlining his report on the puzzlingly low CPI number, “Captain Phillips goes overboard.”