Federal Reserve officials this week are expected to raise interest rates for the first time in nine years on the expectation that employment and inflation will hit targets reflecting a healthy U.S. economy.
But Fed officials face a troubling question: Jobs are on track, but inflation isn’t behaving as predicted and they don’t know why. Unemployment has fallen to 5%, a figure close to estimates of full employment, while inflation remains stuck at less than 1%, well below the Fed’s 2% target.
Central bank officials predict inflation will approach their target in 2016. The trouble is they have made the same prediction for the past four years. If the Fed is again fooled, it may find it raised rates too soon, risking recession.
Low inflation—and low prices—sound beneficial but can stall growth in wages and profits. Debts are harder to pay off without inflation shrinking their burden. For central banks, when inflation is very low, so are interest rates, leaving little room to cut rates to spur the economy during downturns.
The Fed’s poor record of predicting inflation has set off debate within the central bank over the economic models used by central bank officials. Fed Chairwoman Janet Yellen, in a 31-page September speech on the subject, acknowledged “significant uncertainty” about her prediction that inflation would rise. Conventional models, she said, have become “a subject of controversy.”
Ms. Yellen faces dissent from Fed officials who want to keep interest rates near zero until there is concrete evidence of inflation rising, voices likely to try to put a drag on future rate increases.