Low inflation is becoming a problem for Janet Yellen and the Federal Reserve. We could be forgiven for thinking low and steady inflation in a growing economy was a good thing. But it wasn’t supposed to be this way.

Forecast models used at the Fed rely in part on something called the Phillips curve. Created by A.W.H. Phillips through his study of wage inflation and unemployment in the United Kingdom from 1861 to 1957, the curve was said to reflect a consistent inverse relationship. When unemployment was high, wages only increased slowly; when unemployment was low, wages rose rapidly.

Fed forecasts have consistently predicted that, as our unemployment rates moved downward over the last several years, wage growth would accelerate, allowing them to reverse the significant easing implemented after 2008. Once we crossed the level they felt represented full employment, currently 4.6%, wage growth would accelerate. Problem is, wage growth has only grown slowly the entire way. Even with a 4.4% unemployment rate (it crossed 4.6% in March), wage growth is unchanged and inflation has actually declined. This isn’t what the models predicted. Furthermore, since that target was created in 2012, inflation has resisted 2% for most of the past five years. There are some economists claiming that the Phillips curve is all but dead. Some critics believe the 2% target was too high in the first place, that various global factors have had the effect of permanently lowering the long term trend of inflation. In any case, the Fed is approaching a fork in the road.

According to Greg Ip, of the Wall Street Journal, this leaves the Fed with basically two choices. In the first option, in a continued effort to raise inflation, they would leave rates lower for longer in the hopes that at some point, and remember that we have been after this for nine years now, the economy would pick up a faster growth rate and wage inflation would finally accelerate. “Raising inflation half a point could require letting unemployment drop to around 3.5% and keeping it there for about five years.” Then the Fed would gradually slow the economy and guide the unemployment rate back over 4%. That’s the theory, anyway. Research from Goldman Sachs suggests that over the last 70 years there is zero evidence that an increase of that magnitude has occurred without a recession, managed or otherwise. How confident are you in the Fed’s ability to turn monetary and economic theory into reality?

The downside to this option is continued financial excess. If you believe low rates have contributed to a misallocation of resources and sub-par GDP growth so far, what will five more years of the same do?

The second option is to discard their inflation target altogether and accept a range of 1.0 – 2.0%. This would acknowledge that, for reasons not entirely yet clear, we have entered into a different era with a lower trend inflation rate, an environment that anyone outside the economics profession sees as a good thing. The second option is far more unappetizing than the first to the Fed because it represents a powerful blow to their credibility. They have spent years assuring investors they had the appropriate tools to accomplish their policy objectives, only to find themselves coming up short on the most visible measures. We think the Federal Reserve has already dented their credibility by keeping rates so low for so long for so little return. Their tools haven’t worked like we were led to believe they would. We think it is time to discard the target.

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