Is It Time To Rethink 2 Percent Inflation?

Federal Reserve Weighs Conflicting Data

SMITH BRAIN TRUST – What happens when the two key pieces of economic data suggest different paths for interest rates in the United States? The situation is playing out now, as the Federal Reserve maps a course for interest rates. Key jobs data indicate the return of full employment, signalling strength in the economy, but key inflation metrics signal an underlying weakness.

“There’s a disconnect,” says Robert J. Windle, professor of logistics, business and public policy at the University of Maryland’s Robert H. Smith School of Business. And it has some people questioning whether it’s time to recalibrate the Fed’s 2-percent target inflation rate.

The Federal Reserve sets interest rates according to its so-called dual mandate – achieving maximum employment and stable prices. And while the Fed doesn’t observe a target level for unemployment, it does have a target level for inflation – 2 percent.

The notion is that if inflation trends above 2 percent, the Fed will seek to cool the economy by raising interest rates, which dampens borrowing and overall economic activity. However, if the inflation rate trends below 2 percent, the Fed will try to stimulate the economy with more accommodative monetary policy – for example, by lowering its key interest rate.

Lately, inflation has lagged below that 2-percent threshold. The consumer-price index for November, the latest month for which data are available, showed just a 1.7 percent year-over-year rise in core prices, the measure that strips away the more-volatile food and energy prices.

“So we are below 2 percent inflation, but the economy seems to be getting to a point where it could potentially be overheating,” Windle says. “So what should the Fed do? Should it abide by its 2 percent inflation target, which says that it shouldn’t raise interest rates at this point, or should it ignore that and increase rates because the employment picture suggests that now is a good time to do that?”

Among the risks, Windle says, is that a long period of “loose” or accommodative monetary policy – low interest rates – can lead to asset bubbles, as investors reject the safety of government bonds, pouring their money instead into equities and real estate, stomaching added risk in search of higher yields than they’d get from government securities.

“The result is asset bubbles, inflation in the asset markets, and the Fed doesn’t want to have that either,” Windle says. “So the Fed is in a bit of a bind. It could change the rule – change the inflation mandate – but that just says to markets ‘I don’t like the rule.’ ”

Already, there is talk of potential asset bubbles. On Wall Street, stocks have been on a nine-year rally. The Dow Jones Industrial Average climbed about 25 percent last year, and the S&P 500 about 20 percent, both striking historic highs. Meanwhile, growth in real-estate prices in U.S. cities has been consistently outpacing wage gains.

And that brings some to question the wisdom whether 2 percent is too high a target for inflation. The issue, Windle says, is the subject of “constant debate.”

“There’s nothing sacred about 2 percent,” he says. “There are arguments that it should be zero, that inflation is inherently bad. If the mandate of the Fed is price stability, the argument goes, shouldn’t the inflation rate be zero?”

There are arguments, as well, for a 1-percent inflation target, or a 1.5-percent. As the newly appointed Jerome Powell takes the helm of the Federal Reserve, replacing former Fed chair Janet Yellen, those arguments could take on a new intensity.

The 2-percent rule was adopted by the Federal Reserve and some of its advanced economy peers largely because of the sense that an economy is far better off with a little inflation than a little deflation. Deflationary pressures, as we saw in the recent housing crisis, can be catastrophic and hard to reverse. “If you get big bouts of inflation or deflation, the world becomes a pretty scary place for some people,” Windle says.

Most economists expect the Fed to continue to push rates higher in 2018, anticipating three quarter-point interest rate hikes. And most are expecting inflation to pick up.

“I think if we get to a point where the economy is clearly overheating, and we still don’t have inflation, that will be an interesting situation,” Windle says. “That’s where you would seriously consider revising the Fed’s guidance – when you have a serious disconnect between the rule and what you are doing in practice.”

“But I don’t think we are there yet.”