The Fed says incessantly that “price stability” is part of their dual mandate and they are committed to maintaining the purchasing power of the dollar. But the Fed has a funny definition of price stability.
Common sense says price stability should be zero inflation and zero deflation. A dollar five years from now should have the same purchasing power as a dollar today. Of course, this purchasing power would be “on average,” since some items are always going up or down in price for reasons that have nothing to do with the Fed.
And how you construct the price index matters also. It’s an inexact science, but zero inflation seems like the right target. But the Fed target is 2%, not zero.
If that sounds low, it’s not. Inflation of 2% cuts the purchasing power of a dollar in half in 35 years and in half again in another 35 years. That means in an average lifetime of 70 years, 2% will cause the dollar to 75% of its purchasing power! Just 3% inflation will cut the purchasing power of a dollar by almost 90% in the same average lifetime.
So why does the Fed target 2% inflation instead of zero? The reason is that if a recession hits, the Fed needs to cut interest rates to get the economy out of the recession. If rates and inflation are already zero, there’s nothing to cut and we could be stuck in recession indefinitely.
That was the situation from 2008–2015. The Fed has gradually been raising rates since then so they can cut them in the next recession. But there’s a problem.
The Fed can raise rates all they want, but they can’t produce inflation. Inflation depends on consumer psychology. If the Fed raises rates without inflation, those higher real rates can actually cause the recession the Fed is preparing to cure. This article shows the Fed is now considering some radical ideas to get the inflation they desperately need.
One idea is to abandon the 2% inflation target and just let inflation go as high as necessary to change expectations and give the Fed some dry powder for the next recession. That means 3% or even 4% inflation could be coming sooner than the markets expect.