With the U.S. economy humming along at its fastest clip in more than a decade, the Federal Reserve should be confident about its ability to weather a global slowdown and start lifting interest rates around the middle of next year.
But then there is inflation.
Interviews with Fed officials and those familiar with its thinking show the mood inside is more somber than the central bank's reassuring statements and evidence of robust economic health would suggest. The reason is the central bank's failure to nudge price growth up to its 2 percent target and, more importantly, signs that investors and consumers are losing faith it can get there any time soon.
Despite undershooting the goal for three years, the Fed has long succeeded in convincing markets that the target was within reach. However, inflation expectations have begun slipping in recent weeks, threatening to amplify downward momentum from plunging energy prices and stuttering global growth.
Barring a turnaround, Fed officials would hesitate to raise interest rates as soon as mid-2015 even as gradually as their forecasts now suggest. On Friday, prices of short-term interest rate futures showed traders pushed back their expectations for a "lift-off" in rates from near zero until October 2015, later than most Fed officials have signaled so far.
"The primary concern at the moment is whether you can get back to 2 percent in a way that keeps expectations anchored, and maintains the credibility of the Fed as an institution that can achieve its goal," said Jeffrey Fuhrer, the Boston Fed's senior policy advisor.
At first sight, a combination of economic growth of nearly 4 percent, falling unemployment and price increases of around 1.6 percent looks good. Central bankers worry, though, that inflation, instead of picking up further, could head the other way.
RESISTING THE URGE
For the Fed, 2 percent inflation provides a necessary buffer against deflation, and sufficient leeway to leave crisis era "zero lower bound" on interest rates behind and start using them as the main policy lever again.
"We're below the Fed's 2-percent target now, but what if we get to 1 percent? And then 0.5? You need to cut that off," said former Fed Vice Chairman Alan Blinder, who teaches at Princeton University.
One Fed official, who declined to be named, told Reuters policymakers must resist the urge to lift rates at the first opportunity because they might be forced to backtrack if inflation failed to pick up.
Narayana Kocherlakota, who has been a dissenting voice and voted against ending the Fed's bond buying program in October, says time is ripe for the Fed to come clean on inflation and act.
"A key for us would be to be communicating effectively and then taking actions to live up to that communication that we are trying to get inflation back to 2 percent as rapidly as possible," the Minneapolis Fed president said last in November.
Other officials, who declined to be named, were not ready to sound alarm yet but said that if inflation continued to disappoint the Fed would have to admit it did not know how long it could last, or how it might shape longer-term expectations.
They also flagged a growing concern that oil prices, which hit a four-year low below $70 a barrel on Friday, will depress the "core" price measures the Fed uses to steer its policy.
For now, however, most policymakers opt to stick with the tried-and-tested theory that monetary stimulus and accelerating growth will eventually lift inflation and fear that airing their doubts could make the Fed's target even harder to accomplish.
Reflecting such fears, the Fed's Oct. 29 policy statement left out references to recent market turmoil and economic weakness in Europe, Japan and China, while downplaying a drop in market-based inflation gauges.
The meeting's minutes, released later, showed policymakers raised those concerns but decided not to air them to avoid undermining investors' confidence in the U.S. recovery.
"I think deep down they are worried about un-anchoring inflation expectations," said Vincent Reinhart, chief U.S. economist for Morgan Stanley. Reinhart, who led the Fed's monetary affairs division in the early 2000s, described recent Fed statements as "tone deaf" on downward price pressures.
Primary dealers surveyed by the Fed still expect inflation to reach 2 percent by 2016, roughly matching central bankers' forecasts. Other measures, however, have slipped.
Prices of inflation-protected bonds show inflation expectations near three-year lows and a survey by the University of Michigan showed consumer expectations hit the lowest level since 1992.
Furthermore, economists surveyed by the Philadelphia Fed now see inflation averaging below 2 percent at least until 2017 whereas only three months ago they expected the Fed to hit its target by the first quarter of 2015.
William Dudley, the influential New York Fed president, hinted at the possible response to a further cooling in prices, saying last month the central bank could run the economy "hot," keeping rates low longer than what growth and jobs data would have suggested.