Why the Fed is hoping for 2 percent inflation
The importance of the target inflation rate is that it serves as an anchor, a predictable and defined gauge to reflect the underlying consumer demand for goods and services which drives the American economy. The target rate is not arbitrary, nor is it selected by chance. The Fed judges that a 2 percent inflation rate, over the long-term, is the ideal healthy balance between price stability and economic growth. When inflation is too low, it indicates a reduced consumer demand for goods and services, declining wages and a weakened economic condition. If inflation is too high, the Fed risks rising prices outpacing consumer wages, eroding American’s buying power. This would curtail consumer purchases, causing a sudden decline in economic growth.
The Fed’s main tool to achieve this balance is by adjusting the fed funds interest rate, upon which short-term debt is often based. Lower interest rates on credit induce consumer spending. Conversely, raising the cost of debt acts as a deterrent on spending, costing consumers more to purchase goods and services.
Since December 2016, the Fed has enacted three 0.25 percent rate hikes, with another hike expected at its Wednesday, Dec. 13 meeting. But since January, inflation has been on a steady decline, falling from 1.9 percent to just 1.4 percent, well below the Fed’s desired target. Moreover, inflation hasn’t reached 2 percent since April 2012 and the U.S. hasn’t experienced a full year of 2 percent inflation since 2008. So, if inflation remains stubbornly low, why then has the Fed been raising interest rates?
The answer lies in the economic model used by the Fed for forward looking projections on inflation. The Fed relies on the economic concept of the Phillips curve, which argues an inverse relationship between unemployment and inflation. A rise in one leads to a decline in the other. The theory states that declining unemployment leads to a greater number of employed workers while also driving wages higher, as businesses must compete for a declining pool of skilled workers. A fully-employed workforce with higher wages would thus increase demand for goods and services, pushing inflation higher.
But clearly, reality is not matching the Phillips curve projections, and the Fed is admittedly confused on why low inflation and tepid wage growth remain despite the tailwinds of a strengthening economy and exceptionally strong labor market. The Fed continues to insist that low inflation and wages are transitory, and at some point, will “catch up” to an unemployment rate already near a 17-year low. By its own projections, the Fed doesn’t believe a 2 percent inflation rate will be met until 2019. However, it appears committed to an agenda of interest rate hikes, including three more in each of the next two years.
For now, the Fed is resolved to its forecasting models, which predict that inflation and wage growth will gradually return. If they don’t return, the impact from multiple rounds of interest rate hikes could put a sudden halt to consumer spending, and ultimately, economic growth. I’ve never found myself actually cheering for an economic forecasting model before, but given what’s at stake, maybe I should start.
Mark M. Grywacheski, Investment Advisor
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