Inflation, strangely low, holds key to 2014 Fed policy

But there is a hitch: inflation has been drifting down for much of the last two years, measuring a feeble 1.1 percent in November by the Fed's preferred gauge. The longer it lingers well below Fed's 2-percent goal, the more at least a few policy makers worry it is a sign that the recovery might not be as strong as it looks. In theory, inflation should rise as the job market heals.

"There's a lot we don't know about inflation," said Eric Stein, a portfolio manager for Eaton Vance in Boston. "I think it's certainly frustrating to them."

Both Boston Fed President Eric Rosengren and Chicago Fed President Charles Evans have referred to stubbornly low inflation as a "puzzle," and have warned that the longer it persists, the more likely it is that there is something rotten in the state of the economy.

"Most people are assuming it's temporary, but the longer we continue to not see it move back to the 2 percent goal, the more we have to be concerned that there are things going on that we have not fully incorporated in the model," Rosengren told Reuters this week.

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But understand it or not, the inflation data is key. The US Commerce Department's personal consumption expenditure index of inflation, which the Fed follows closely, is "the critical monthly statistic for analyzing Fed policy in 2014," Pimco's Bill Gross, manager of the world's largest bond fund, said in his monthly letter to investors.

Outside the measure most closely watched by the Fed, which strips out food and energy costs, there is little evidence of momentum for higher prices, in the United States or elsewhere.

The Commerce Department says goods prices through November had fallen for four straight months on a year-over-year basis, and larger-ticket durable goods items were down by nearly 2 percent from a year earlier, the fastest annual decline in nearly three years.

Moreover, recent commentary from US retailers indicated that many relied heavily on discounting to lure shoppers during the recent holiday sales period. And it's not just a US problem.

Euro zone inflation fell unexpectedly in December from the month before, increasing the European Central Bank's challenge of avoiding deflation as well as supporting the bloc's recovery.

There are "miles to go ... before a policy rate hike," Gross said, predicting the Fed will only start raising rates in 2016.

Janet Yellen, who will take the reins as Fed chief after Ben Bernanke's term ends January 31, has been particularly attuned to the threat of too-low inflation, explaining at a 1996 Fed policy-setting meeting that when inflation falls below 2 percent, "nominal rigidity begins to bite," pushing up permanent unemployment.

A certain amount of inflation, say 2 percent, is necessary to grease the wheels of the economy and put downward pressure on unemployment, she argued then. As head of the Fed's communications sub-panel, Yellen helped get the 2-percent inflation goal enshrined two years ago as an explicit policy aim.

To Yellen, high unemployment is simply unacceptable. "Long spells of unemployment are particularly painful for households, impose great hardship and costs on those without work, on the marriages of those who suffer these long unemployment spells, on their families," Yellen said in her confirmation hearing last year.

And that very focus on unemployment, and her recognition that too-low inflation can be a contributing factor, is why "inflation is the key dynamic for Yellen and the Fed this year," according to Lou Brien, a Chicago-based analyst for DRW Holdings. "The labor market is not unimportant, just less so for their policy decisions."

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At the same time, if inflation does begin to pick up back toward 2 percent, as many policy makers think it will, the Fed could have less leeway to be patient on its removal of stimulus.

Minneapolis Fed President Narayana Kocherlakota, who wants the Fed to add to rather than pare its stimulus, made that point in a town hall meeting Thursday evening.

While the Fed is "failing to deliver effectively" on its promise to keep inflation at a predictable 2 percent, he said, the fact that it continues to stay low means the Fed can ramp up stimulus without the constraint that higher inflation would impose.

Some policymakers, including the hawkish Kansas City Fed President Esther George, take the view that low inflation readings currently are an aberration, caused by lower-than-usual healthcare costs, changes in the way the price index is calculated, and low import prices.

To George, the real danger is potentially higher future inflation should the Fed continue to add assets onto its now nearly $4-trillion balance sheet.

Others, like centrist San Francisco Fed President John Williams - seen as closely allied with Yellen, who was his boss when she headed the San Francisco Fed - believe inflation has "clearly bottomed," as he told reporters this week in Phoenix.

Even Rosengren and Evans, who have raised questions about why inflation is so low, predict it will rise back to 2 percent in coming years.

"Because inflation surprised to the downside in 2013, it remains a wild card for the Committee in 2014," St. Louis Fed President James Bullard said on Friday, nevertheless forecasting it will edge up to about 1.6 percent this year.Yellen, in her only interview since she was confirmed Monday, signaled she agrees with that take.

"The recovery has been frustratingly slow, but we're making progress in getting people back to work, and I anticipate that inflation will move back toward our longer-run goal of 2 percent," Yellen told Time Magazine on Monday, the day her nomination to the Fed chair received final Senate approval.