Reading the news or browsing social media, it may seem like there’s little consensus to be had over any issue. But whether it’s consternation over the price of a gallon of milk at the grocery store or water cooler talk about the Federal Reserve’s interest rate decisions, we can all agree on who the bad guy really is. Inflation.
In reality, inflation does seem like it should be a rallying point. When inflation is high, we all pay more for groceries, gas, utilities, housing, and many other living expenses. So why then does the Federal Reserve set a target inflation rate of 2% instead of 0% or even a negative target (known as deflation)? Because the consequences could be worse for the economy and consumers.
What is inflation?
Inflation, in a basic definition, is the rate of overall price increases over a period of time. It’s measured by the consumer price index from the Bureau of Labor Statistics (BLS), which takes into account the prices of a variety of goods and services, weighted more heavily towards those items we spend more on. At any given time, there will be some prices within the CPI that are falling while others are increasing. But most of the time most prices are going up, which means there is inflation. Modest inflation is generally a sign of a growing economy, while deflation – most prices decreasing over time – is nearly always associated with economic contraction.
It's important therefore to promote an environment where the economy is growing at a healthy rate without outpacing consumers’ ability to afford the goods and services produced. To help find that balance, the Fed’s primary tool to influence inflation is manipulation of the federal funds rate – the interest rate at which banks lend their reserves overnight to one another. It can raise rates to slow the economy if inflation is too high or lower rates to boost inflation and encourage spending during an economic downturn.
“It’s a common misconception that any kind of inflation is automatically a bad thing,” said PNC Chief Economist Gus Faucher. “While rapid inflation stresses consumers and hurts the economy, modest inflation is usually indicative of a healthy economy with stable employment metrics and wage growth.”
Targeting 2%
But even if it were possible to agree that inflation on its own isn’t necessarily bad, deciding on a target rate of inflation has not been a process full of consensus. In fact, a target inflation rate is still a relatively new concept. Inflation is as old as currency, but the Fed didn’t settle on a target inflation rate of 2% until 2012. That number is the result of years of internal debate at the Fed and study of other developed economies’ experiences with inflation targets.
The official position is that 2% inflation is the optimal rate at which the Fed fulfills its mandates of maximum employment and price stability. At much higher levels, inflation would overstress consumers and lead to reduced confidence in the economy. Deflation, however, can set an expectation among consumers of further price drops, thus leading them to delay purchases, which can exacerbate downturns. The Fed also argues that below-target inflation can hamper its ability to fight recessions through interest rate cuts.
In some circles, the 2% target inflation rate might be up for debate. But one thing that is clear is: though consumers love lower prices, rapidly falling prices are bad for the economy. Dips in the CPI are exceedingly rare – with the index only falling 14 years is its more than 100-year history, and just once since 1955 (in 2009) – and almost always indicative of a recession. And while deflation leads to lower prices, it’s often accompanied by diminished purchasing power among consumers and high unemployment.
Two examples in U.S. economic history are the Great Depression of the 1930s and, more recently, the Great Recession. Of the 14 dips in the CPI, 7 of those occurred during those two economic downturns. Both periods were marked by reductions in prices and peak unemployment rates in the double-digits.
“It’s understandable that consumers would want quick action to bring inflation in check and prices to a growth to a palatable level,” said Faucher. “But it’s something that needs to be done with careful economic and monetary policy planning to avoid unintended negative consequences.”
