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This is an excerpt from our most recent Economic Outlook report. To access the full PDF, please click here

Low inflation rates remain a puzzle to central bankers around the world, including Japan and the Euro zone. As the Federal Reserve lays the groundwork for a further normalization of its policy instruments, it is finding it difficult to explain the sticky low inflation tied to the strong US economy.

The low inflation is puzzling because economic theory and empirical evidence suggests that increases and decreases in the monetary supply or interest rates set by central banks in the past caused – or at least were correlated with, rises and falls in the inflation rate. The fact that this relationship does not appear to hold currently might hamper the Fed’s plan to gradually increase rates throughout this year and even its balance sheet plans.

There are several possible explanations why low interest rates and low unemployment have not manifested in higher inflation rates yet. Fed Chairwoman Janet Yellen has attributed the recent weakness to declines in the prices of particular goods, such as cellphone-service plans and prescription drugs that are not likely to continue. She and other officials also have noted that the weakness of the global economy allowed the United States to import foreign goods at low prices.

Another countervailing view emphasizes the importance of real economic conditions. Low inflation has become a prevalent condition across a number of developed countries. A possible explanation is that growth in emerging economics introduces competitive forces, which help to hold down wages, while the importing of goods from foreign countries helps to put a cap on prices.

Another major factor contributing to subdued wage growth (which has not returned to the levels before the financial crisis) is the pressure through the civilian labor force participation rate. This has increased steadily in the last two years, after a strong decline in the aftermath of the financial crisis. See below.

If this incremental increase in the U.S. labor force is successfully absorbed into the U.S. economy, we expect increased wage growth to finally contribute to the inflation level.

This is an excerpt from our most recent Economic Outlook report. To access the full PDF, please click here

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