The Inflation Enigma: The Fed's flying with blinders on.

• Author: Ullmann, Owen
• Position: View from the Beltway

The U.S. economy has been on a tear. Growth is humming along at about 3 percent, unemployment hit a fifty-year low of 3.6 percent in April, stock market gains have goosed consumer spending, and worker wages are finally rising, all as the current expansion became the longest in history this summer.

And inflation? For seven years it has limped along at less than 2 percent.

That's not supposed to happen according to the conventional economic models, particularly when a persistent decline in productivity from the 1990s was expected to spill over into price inflation. Like most private economists, the Federal Reserve anticipated that strong growth--juiced by the 2017 tax cuts--and tightening labor markets would trigger higher inflation. So it hiked interest rates throughout 2018 to combat what has turned out to be a phantom threat.

Low inflation seems embedded in the U.S. economy--indeed, the global economy--and the sharpest minds are stumped as to why. There are many theories to explain the current set of circumstances, but no one is sure whether this period of low inflation is transitional or part of a long-term trend resulting from a combination of factors that include technology, globalization, and demographics.

"We just don't understand inflation," concedes Jeremy C. Stein, chair of the economics department at Harvard University who served two years as a Fed governor during the Obama Administration. The lack of significant wage inflation in view of all the reports of critical labor shortages is hard to explain, he says. "It may just be temporarily asleep and the labor market tightness might show through eventually, but it is still mysterious."

Understanding the underlying causes of our current low-inflation environment is critical for ensuring sound monetary policy and preventing another financial crisis based on flawed inflation expectations. Are we in a period like the 1960s, when the economy was booming, only to run into an ugly period of high inflation and stagnation in the 1970s? Or have we created a new virtuous cycle that keeps inflation well anchored indefinitely? Everyone wins in the latter case except for heavily leveraged borrowers who cannot count on inflation to lessen their debt payments. A review of the many explanations for low inflation may help determine what the future holds.

Mohammed A. El-Erian, chief economic adviser at Allianz, argues that structural forces are sustaining a disinflationary environment worldwide. "They...