After months of focus on slack in US labour 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.
What if they don't?
That would put the Fed in a bind - with rates at zero, and absent a renewal of the sort of unconventional programs it has been trying to wind down, no tools at hand.
The experience of its Japanese and European peers is far from encouraging.
UPHILL STRUGGLE
The Bank of Japan pulled the economy out of a protracted deflation with a massive burst of stimulus, but its inflation goal remains elusive, leaving it with an open-ended promise of extra loose policy for however long it takes. A similar fight has been underway in the euro zone now for five years.
Fed officials say they are confident the U.S. economy is turning a corner, and have stuck with forecasts showing a gradual rise in inflation over the next year or two that would allow a slow but steady rise in interest rates.
But they have yet to fully explain what has happened in the U.S. economy in the past two years: how a much faster than expected fall in unemployment squares with a much slower than expected rise in inflation. They have also struggled to describe what they might do next - eager to lay the groundwork for an initial rate rise, yet uncertain whether and when it will be possible.
"The Fed is trying to feel this one out...They are trying to be as non-committal as possible," said TD Securities analyst Gennadiy Goldberg. "They don’t know when inflation will pick up and when disinflation pressures will stop."
Central banks seek to maintain a steady, moderate inflation to keep wages and spending growing, lower relative costs of debt and allow them to use interest rates as the main policy lever.
Fed officials acknowledge that if inflation weakens further, they might need to do more by strengthening their commitment to keep rates low for longer or, in an extreme case, revive the bond buying program. While that is not their forecast, the recent market dive and Europe's weakness reopened a conversation U.S. central bankers thought they had left behind.
"If we don’t see wage growth or the price inflation that I am looking for then it would be appropriate in my view to further stimulate aggregate demand," said Williams, who was one of several Fed officials in recent days to note that if the economy veers off course they will respond.
Research at the Fed and elsewhere in recent years has delved into how the evolution of the global economy may have changed the way wages, prices and output interact.
Among the possible forces at play, Fed research has noted a steady decline in workers' share of U.S. national income, a result of the shift of manufacturing jobs overseas, technology investment that has raised productivity faster than wages, and perhaps even the decline of labor unions and their bargaining power. The drop in labor's share, which is expected to continue, means wages no longer drive inflation as much as they did in the past.
"You are not seeing the type of wage pass through dollar for dollar you used to see. The dynamic has just changed," said Sheryl King, senior director of research at Roubini Global Economics.
Outsourcing of production and, increasingly, services overseas may continue to temper inflation; the increasing use of part-time labor, the more rapid rise of lower paid work and automation could also be at play.
All told, the cross-currents are hard to read. The drop in oil prices helps energy intensive firms and consumers, but it could also be a symptom of global economic weakness and dent investment in a thriving sector of the U.S. economy.
"From the perspective of the 1970s you'd say this is crazy. Because normally slack gets removed much more quickly, and you would have stronger inflation," Chicago Fed President Charles Evans said in Indiana last week. "That does not seem to be anything like what we are experiencing now."
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