Distortions in Inflation by comparing Long Run Natural Inflation to Fed Inflation Target

People are talking about low inflation and possible deflation. (Krugman today, and this article by St. Louis Fed, thanks Marko). Many think inflation will rise back up. Some think inflation can turn into deflation. The video above gives my view using a model of System Dynamics. (Link to first video describing model.)

I show a model that says inflation is simply relaxing into a natural level as determined by a long run Fisher Effect. My view is that we will see low inflation become stable, like happened in Japan. Basically, when the “long run Fisher Effect natural inflation level” is lower than the Fed’s target inflation rate, the Fed nominal rate will slowly slide downward overtime to the zero lower bound.  The Fed rate slides lower over time to work against the tendency of inflation to decline. (see video) Eventually the Fed rate hits the zero lower bound and loses power. Then the Fisher Effect takes over and moves inflation. However, inflation will not collapse. Inflation at that point will simply relax downward to the natural long run level as determined by the Fisher equation.

No big worries. Inflation is just settling into a lower and natural long run steady state as determined by the Fisher Effect. I see little chance of inflation rising back up unless some variables raise the “long run Fisher Effect natural inflation level“. The Fed would need to raise their projected Fed rate at full employment, which the Fed projects to be 2%. That is lower than a normal 4%. Projecting a lower Fed rate at full employment leads to a natural inflation level which is lower than the Fed’s inflation target.

How can the Fed generate projections of a higher Fed rate at full employment? Very carefully as my father used to say. But if the Fed could project a higher Fed rate in their forward guidance, the natural level of inflation would rise. That is the key to solving low inflation into the future.

Note: The Fisher Effect assumes that the natural real rate is independent of monetary policy and is simply based on productivity, labor force growth and growth of real output.