With the U.S. inflation rate about half of the Federal Reserve's 2% target, the central bank is facing a major test and some experts wonder whether it will eventually need to ramp up its already aggressive bond buying program.
The Fed cut official interest rates effectively to zero in late 2008 during the financial crisis. Since then, it has bought more than $2.5 trillion U.S. in bonds to bolster an anemic economic recovery and speed up the decline in unemployment.
Despite those actions, its favored inflation gauge, the Personal Consumption Expenditures (PCE) price index, has fallen to a 3-1/2 year low of 1%
Further, by the Fed's own forecasts, inflation is likely to remain short of the central bank's target for years.
For now, however, Fed officials do not view the decline as a signal of a worrying deflationary threat.
At its policy meeting last week the central bank decided to continue with its $85 billion U.S. a month in bond purchases, and a statement announcing the decision offered no hint of panic.
In its statement the Fed stuck with a characterization of inflation as "running somewhat below" its target, a phrase it had been employing since December.
Officials have taken solace in the relative stability of inflation expectations, which are seen as a leading indicator of actual inflation.
The spread between Treasury notes and inflation-linked bonds, a measure of investors' inflation perceptions, has eased gradually this year to its lowest levels since last autumn. But it is still far above the lows seen in 2012, before the Fed launched its latest and third round of bond buying or "quantitative easing".
Indeed, a daily deflation probability gauge produced by the Atlanta Federal Reserve Bank that is based on bond market measures currently reads zero, a level unchanged since February.
Policymakers can also take some comfort from a growing gap between the inflation gauge they target and the more popular consumer price index. CPI inflation has been running at much higher rates which may suggest the decline in the PCE price index will prove transitory and turn around if economic growth picks up as expected towards the end of 2013.
While the PCE price index rose just 1% in the year through March, and its core counterpart was up just 1.1% the CPI was up 1.5% and the core CPI climbed 1.9%. It is the biggest gap between the two core measures in a decade.
