Rate cuts with little risk? The unexpected taming of US inflation.

Inflation – the rip-roaring variety that skyrocketed prices in the 1970s and shrunk pay raises to irrelevance – has gone missing for a long time in the United States.

Even in boom times, like now, price rises have been tame. And no one is quite sure why.

Against this backdrop, the Federal Reserve today cut interest rates for the first time since the Great Recession a decade ago. It’s a sign that the central bank is far more worried about the economy slipping back into recession than high inflation rearing its head again. 

On one level, the Fed’s quarter-point rate reduction makes sense: Why not help the economy a little bit with lower rates when trade tensions threaten to get out of control? On another level, however, it flouts decades of conventional economic thinking about consumers and their expectations about inflation.

“It’s really, I think, a sea change in how people view inflation expectations,” says Tim Duy, a Fed watcher and economist at the University of Oregon in Eugene. “It’s really a different policy environment.”

Like much of economics, the dynamics of inflation depend in part on people’s outlook – or expectations. If consumers anticipate lots of inflation ahead, they go out and buy things before the price goes up. That pushes up demand, which raises prices, and creates a self-fulfilling prophecy. That’s what happened during the 1970s.

Since then, inflation has become far tamer and those inflation expectations have dampened. That’s the sea change. Consumer inflation expectations seem permanently lowered – or anchored, to use the economists’ term – so that even a noticeable rise in inflation is viewed as temporary. And central bankers are beginning to act accordingly.

“It gives them some leeway to be able to ease” interest rates even if the economy hasn’t begun to contract, says Laurence Ball, an economist at Johns Hopkins University in Baltimore. And if they ease too much and inflation jumps to 3% instead of its 2% target, “that doesn’t really seem like a grave threat to the country.”

The bigger threat is a downturn, Fed Chairman Jerome Powell said in his statement at today’s press conference. “Inflation’s return to 2% may be further delayed and … continued below-target inflation could lead to a worrisome and difficult to reverse downward slide in longer-term expectations.”

There is some precedent for preemptive rate cuts. During the 1998 Asian financial crisis, the Fed lowered rates in case the downturn spread to the U.S. (It didn’t.) In September 2007, the Fed stepped in with a rate cut in case the economy went into a tailspin. (It did, big time.)

If now the Fed has thrown off the boogeyman of 1970s-style inflation, it still faces the key question of why inflation hasn’t been stronger during the longest economic expansion in U.S. history.

When the economy is booming and businesses are hiring, demand soars for goods and services. Prices are supposed to rise in response. That’s always implied in the past a trade-off for the Fed: It can have low unemployment and high inflation or high unemployment and low inflation.

But in this boom, that relationship has broken down. The unemployment rate is near 50-year lows but inflation has also stayed low. The annual change in so-called core inflation, which excludes volatile energy and food categories, has been lower than the Fed’s 2% annual target for long periods of time. By one measure, core inflation in June was 1.6%.

Can the Fed thus ignore inflation and goose the economy by more rate cuts, as President Donald Trump is pushing for? It depends, in part, on whether that trade-off is permanently broken.

There are many theories for why inflation has been so quiescent during the boom. It could be globalization, which allows Americans to import lower-priced goods when demand rises. It could be that technology is making some electronic goods cheaper. According to Mr. Ball, the Johns Hopkins economist, the problem lies with the way the Fed measures inflation.

Measured his way – which not only removes food and energy but takes into account other goods and services that have big price movements in a given month – inflation is actually right around the Fed’s target.

Future rate cuts could also be influenced by how much pressure the Fed is feeling from the markets and the administration. After the Fed briefing, in which Mr. Powell suggested the cut was not the start of a long series of cuts, the stock market dropped sharply. The Dow Jones Industrial Average fell more than 330 points.

The market pressure probably plays a small role in persuading the Fed to cut rates, says Sarah Bloom Raskin, a visiting fellow at Duke University School of Law and former governor of the Federal Reserve Board. As for the president, “they’re not directly responding to his bullying them but they are finding a rationale that is essentially Trump’s doing, which is the volatility in the trade war. ... All Trump needs to do, going forward, is to keep uncertainty high on trade tensions and he’s going to have the Fed right where he wants it.”

The Fed’s future direction would be clearer if economists could reach a consensus on why inflation is so tame right now. But consensus can also lead to complacency.

“I worry about that all the time,” says Mr. Duy of the University of Oregon. “As soon as we get our story straight on this stuff, boom, the story is going to change.”