SAN FRANCISCO (Reuters) – Despite a U.S. labor market that has been “nothing short of extraordinary,” the Federal Reserve is falling short on its 2-percent inflation goal, undermining the U.S. central bank’s credibility and undercutting its ability to make effective monetary policy, San Francisco Fed Bank President Mary Daly said on Tuesday.

“We’ve grazed 2 percent here and there, including briefly last year,” Daly said in remarks prepared for delivery to the Commonwealth Club in San Francisco. “But it hasn’t been sustainable.”

Low inflation makes the chance of an outright decline in prices more likely, Daly said. Deflation drains growth by encouraging consumers and businesses to put off spending and investment.

Low inflation also makes it harder for the Fed to cut interest rates to stave off downturns.

But most importantly, it eats away at the Fed’s credibility, she said. And now there are signs that inflation expectations are on the decline.

“We need to be vigilant on this front, and work to deliver 2 percent inflation on a sustained basis,” she said. “The Federal Reserve’s continued credibility with consumers and businesses depends on it.”

Daly’s comments on the threat of too-low inflation go some way to explain Fed policymakers’ decision last Wednesday not only to keep their target for short-term rates in the range of 2.25 percent to 2.5 percent but to mostly abandon projections for any interest rate hikes this year.

Fed Chair Jerome Powell cited slowing economic momentum and risks like trade tensions as reasons for putting further rate hikes on hold, and said that close-to-target inflation gives the Fed room to be “patient.”

Daly’s comments Tuesday show that there is at least some worry internally at the Fed low inflation may represent a downside economic risk in itself.

Daly outlined a number of reasons why 3.8 percent unemployment is not driving up inflation or wages, including that companies are using non-wage benefits to entice workers.

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Automation, globalization, and a decline in unionization are making it harder for workers to demand higher wages, she and others argue. And companies, faced with rising global competition, resist raising wages because they cannot raise their prices.

The Fed’s success in tamping down inflation after the economic shocks of the 1970s has also played a role, she said. Keeping consumers and businesses bought into the idea that the Fed will not let inflation run rampant again has kept inflation expectations anchored, she said.

Daly does not vote on the Fed’s policy decisions this year, but participates in regular policy deliberations, the next of which will take place April 30 – May 1.

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