You Decide: Why stop at an inflation rate target of 2%?

Published 3:22 pm Saturday, January 6, 2024

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By Mike Walden

At their recent meeting, the leaders of the Federal Reserve (Fed) indicated they would likely reduce their key policy interest rate in 2024, perhaps multiple times. If the Fed indeed does this, most interest rates in the economy would also drop. This would especially be good news for households wanting to borrow for big ticket purchases, like homes, vehicles, appliances and furniture. Lower interest rates would also boost economic growth.

The Fed began raising its key interest rate in early 2022 in an attempt to stop the surging inflation rate, which peaked at a year-over-year rate of 9.1% in June 2022. Results show the Fed is succeeding. The most recent year-over-year inflation rate for November came in at 3.1%.

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The Fed has stated on numerous occasions that its goal is an annual inflation rate of 2%. This is close to the inflation rate prior to the pandemic. However, the Fed’s stated goal raises the obvious question: Why stop at a 2% inflation rate? Why not go to zero price inflation, or even better, why not have a goal of negative inflation, meaning prices are falling?

These are excellent questions. In today’s column, let me try to explain why the Fed wouldn’t want to pursue a zero or negative inflation rate, and then let you decide if the Fed’s reasoning makes sense.

The first reason is based on the Fed’s mandate. Congress has directed the Fed to use its tools to accomplish two goals — keeping the economy growing fast enough to maintain low unemployment while also keeping the inflation rate low. One of the major tools the Fed uses to meet these goals is moving interest rates up and down.

If, as we’ve seen recently, the inflation rate is too high, the Fed will use its power to raise interest rates and slow growth in the economy. As the economy slows and spending moderates, upward pressure on prices will be curtailed. We’ve seen this result in recent years.

Conversely, if the economy is growing too slowly, or even more importantly, if the economy is near or already in a recession, the Fed will lower interest rates. We saw this action during the two most recent recessions, the COVID-19 downturn and the downturn during the housing crash in the late 2000s.

Yet there’s a potential problem with this policy if the inflation rate is very low: a link between the inflation rate and interest rates. Because lenders must receive payments high enough to compensate for inflation, inflation and interest rates move together. That is, if the inflation rate is low, interest rates will also be low. If the inflation rate is higher, interest rates will be higher.

The problem is, if inflation is very low — for example, near zero or even negative — then the Fed won’t have much room to lower interest rates to counter a recession. During both the tech recession of 2001 and the housing crash recession of 2007-09, the Fed pushed its key interest rate down 5 percentage points. This wouldn’t have been possible if, for example, the inflation rate was zero and interest rates were 3%.

The second concern about very low inflation comes when the inflation rate goes into negative territory, meaning average prices are falling. On the surface most would expect negative inflation — technically called deflation — would be a good thing. But actually, economists argue deflation can lead to bad things, such as a recession.

How so? There are two possible adverse results. First, if consumers observe prices falling, they may reasonably expect the price declines to continue. This expectation could motivate consumers to delay buying products now with the thought the products will be cheaper later. Of course, delays can’t occur for all products, such as necessities like food and energy, but they could result in big reductions in sales of homes, furniture, vehicles and other large purchases. Since consumer spending accounts for 70% of the economy, a significant reduction in spending due to falling prices could ironically bring about a recession.

For businesses and their workers, falling prices create a second type of problem. Let’s say prices are dropping by 5%. For a representative company, this means the price of the company’s product is down 5%. It also means the prices of inputs the company uses are falling 5%.

But what about labor costs? Will workers be happy with a 5% cut in their pay? From a company’s point of view, if everything costs 5% less, workers won’t be harmed by a 5% wage cut. Still, the psychology of a pay cut — even if it doesn’t reduce workers’ standards of living — will likely cause many workers to resist. The result may be mass firings, disruption of production and economic turmoil: in short, a recession.

There is a final concern many readers will discard, but it does carry some significance. The concern is flaws in the measurement of inflation that result in the inflation rate being overestimated — that is, being higher than it actually is. Due to the challenge of adjusting prices for product improvements and even for new products, research suggests the official annual inflation rate overstates the actual rate by one percentage point.

Hence, another reason for an inflation target rate of 2% is to prevent the actual rate from being close to zero or even negative.

So, what do you think? Is there a case for targeting the inflation rate at 2%, as the Fed is doing?  Are there legitimate reasons for doing this? Or should the Fed go further and attempt to move the inflation rate to zero or even to a negative rate? You decide.

Mike Walden is a William Neal Reynolds distinguished professor emeritus at North Carolina State University.