Fed still behind the curve on inflation

Another upturn in the US inflation cycle is at hand. It was inevitable. Since the Great Disinflation of the early 1980s, when the annual increase in the Consumer Price Index plunged from 14.7 percent in March 1980 to 2.4 percent in July 1983, inflation has generally remained in a relatively narrow 1 to 5 percent range. When the economy softened, inflation slid to the lower end of that range, and when it strengthened in the late 1980s, late 1990s, and in the pre-crisis 2000s, it moved to the upper end. Such is the case today.

Not surprisingly, this pattern has been slow to emerge in the current cycle, largely owing to an unusually weak post-crisis economic recovery. But now a confluence of global and domestic forces is starting to push inflation higher and should continue to do so for some time. That will pose a challenge to the US Federal Reserve, which operates under a price-stability mandate. Recent volatility in stocks and bonds suggests that these risks could prove vexing to financial markets as well.

The global risk of US inflation reflects not only a cyclical upturn in the world economy, but also mounting trade frictions that pose serious threats to the stability of global value or supply, chains. As the global value chains have grown in importance over time, so has the internationalization of inflation. In economic terms, that means broadening the assessment of inflation risks from a focus on domestic "output gaps" - the difference between actual and potential (or full employment) GDP - to the global output gap. Significantly, recent research by the Bank for International Settlements has found that a global output gap of about 1 percent - precisely the outcome for all advanced economies over the past five years-reduces inflation by 0.9 percent.