Economic Modeling in the Post Great Recession Era

CHAPTER 8 Inflation When What You Get Isn’t What You Expect

INTRODUCTION

One of the most persistent deviations between actual and expected outcomes since the financial crisis has been the behavior of inflation. A lack of inflation has been a ubiquitous problem among advanced economies since the global financial crisis, even as monetary policy has been pushed to what can only be considered as ultra-accommodative. With price stability one of the Federal Reserve’s goals mandated by Congress and the primary benchmark of success for other central banks, the dearth of inflation has presented a clear challenge for policy makers seeking to normalize interest rates and employ the traditional tools of monetary policy.

Prior to the financial crisis, central banks had established command over inflation. After stagflation in the 1970s, in which inflation flourished and the real economy languished, monetary policy makers established credibility in fighting inflation by adjusting interest rates. In recent years, however, with interest rates at record lows, inflation continues to run well below what models have predicted. Federal Reserve officials have been steadily nudging down medium-term inflation forecasts while standing pat that inflation will return to 2.0 percent over the longer run.

Policies aimed at stoking inflation back up to more palatable levels have fallen short all across the developed world. Record low interest rates, unprecedented expansion of the monetary base, and even ...