Markets and Economy
Why the Fed Should Keep Its Inflation Target Low
Over the last few years, core inflation has remained tame through every phase of the business cycle, leading to calls for the Fed to raise its 2 percent target. In reality, there are other factors affecting inflation’s counterintuitive behavior—and reasons the Fed should leave its target in place.
Compared to historical examples, inflation has behaved oddly in recent years. Usually, prices are expected to climb as the peak of the business cycle approaches—but in this current cycle, core inflation has remained tame, barely inching toward the Federal Reserve’s 2 percent target even as unemployment falls toward a 17-year low. And investors don’t seem to anticipate prices rising any time soon, as current bond yields still imply inflation averaging just 2 percent over the long run.
Some critics believe that the Fed is overly constrained by its low inflation target. While a higher target would enable a more forceful response to future recessions, the Fed’s ability to credibly anchor inflation expectations has been a major victory for US monetary policy. Inflation’s current behavior may not follow textbook theories, but that doesn’t necessarily mean the Fed should shift its 2 percent target.
How It Works—in Theory
Traditional theories of inflation call for prices to move in response to changing aggregate demand. When the economy is underperforming, excess slack is expected to prevent prices from rising quickly—if the price of goods begins to climb, manufacturers should easily be able to rehire laid-off workers to fill more shifts and increase production. The supply of goods would quickly rise to accommodate demand, stabilizing consumer prices.
At the peak of the business cycle, however, prices would be expected to rise. If unemployment were to fall below a certain threshold, businesses would have trouble staffing up to boost production. Prices would climb as the nation’s ability to supply goods and services failed to keep pace with rising aggregate consumer demand.
Starting with the 2001 recession, however, inflation has deviated from this textbook theory. During that business cycle, inflation remained relatively stable, seemingly immune to swings in aggregate demand. In 2008, the deepest economic contraction since the Great Depression barely dented the rate of inflation. The recovery has removed a lot of slack from the economy, yet the tightening labor market has hardly driven up consumer prices at all.
Is Inflation Broken?
Just because inflation has defied textbook theories in recent years doesn’t mean there’s no link between prices and aggregate demand. A countercyclical shift in global commodities may explain the steady, tame behavior of inflation in the current business cycle.
In the early part of this decade, the US economy was severely underperforming, but a construction boom in China was driving up prices for metals, energy and other raw materials. Higher commodity prices may have propped up the price of consumer goods in the US, despite weak aggregate demand domestically.
Around 2014, China began shifting toward a more sustainable, slower pace of expansion. As a result, commodity prices began to fall, indirectly offsetting the effect of rising consumer demand in the US. In 2015, the global energy glut effectively lowered the cost of production and shipping for most consumer goods, likely helping to contain inflationary pressure as the economy closed in on full employment.
Why Some Are Calling for More Force
Inflation’s tame behavior has led some critics to call for the Fed to adopt a higher target. After all, long-term interest rates are determined by inflation expectations. If expectations are too low, the Fed’s ability to stimulate the economy through rate cuts will be limited.
Today, long-term interest rates are resting near 2.5 percent. In the event of a downturn, the Fed would only be able to cut overnight rates by about 250 basis points. That would encourage borrowing and spur growth somewhat, but it wouldn’t be nearly as effective as a larger cut. In the event of a crisis similar to the 2008 recession, a cut of 500 basis points could be necessary—but also impossible, because the Fed can’t push rates below zero.
A higher inflation target could give the Fed more leeway. If investors expected inflation to exceed 4 percent, higher long-term interest rates would allow the Fed to take extremely forceful action in response to a downturn.
However, the Fed likely already has enough power to address a typical recession. In the event of another severe crisis like the 2008 contraction, the Fed may be forced to adopt unconventional strategies, like quantitative easing. Relying on extraordinary measures during an extreme crisis doesn’t necessarily represent a flaw in monetary policy. There are benefits to maintaining a credible, low inflation target.
A Question of Credibility
The inflation target likely can’t be shifted without risking consequences. By constantly reaffirming its commitment to a 2 percent inflation target, the Fed has built credibility among investors, who have faith in price stability over the long run. The broader economy benefits when businesses and consumers can make investments and plan for the future without worrying about spiraling inflation.
Since the early 1990s, stable inflation expectations have helped bring certainty to the bond market and kept long-term interest rates steady. Currently, low inflation expectations are helping keep monetary policy accommodative as the peak of the business cycle approaches. Moderate inflationary pressure could allow a sustained period of growth in the coming years. Inflation may be behaving oddly, but the Fed’s 2 percent target is still serving the nation well.
View our economic commentary disclaimer.
Jim Glassman, Head Economist, Commercial Banking
Jim Glassman, Head Economist, Commercial Banking
Jim Glassman is the Managing Director and Head Economist for Commercial Banking. From regulations and technology to globalization and consumer habits, Jim's insights are used by companies and industries to help them better understand the changing economy and its impact on their businesses.