What are the Fed’s thoughts on 2% Inflation?
"Low Inflation Vexes Central Bank
Fifteen years ago, Japan found itself stuck with a problem: sinking inflation, interest rates near zero and a limited ability to generate stronger growth and counteract recessions. Five years ago, Europe faced the same challenge.
The worry haunting Federal Reserve officials is that they will be caught in a similar trap within the next decade. This concern is animating their yearlong review culminating with a two-day research conference beginning Tuesday in Chicago.
There are several changes the policy makers could adopt, but the question that is getting the most attention: Should they commit now to policies that would encourage inflation to rise above its 2% target more often?
Under their current framework, Fed officials seek to keep inflation around 2% annually. The problem is that since adopting that target in 2012, inflation has mostly run under 2%, raising concerns that the public will think Fed officials aren’t committed to their stated goal. They fear this could cause consumers and businesses to expect weaker inflation, becoming a self-fulfilling prophecy.
“We’re trying to think of ways of making that inflation 2% target highly credible, so that inflation averages around 2%, rather than only averaging 2% in good times and then averaging way less than that in bad times,” Fed Chairman Jerome Powell said in February.
The Fed decides whether to adjust interest rates based on a broad array of economic data, along with inflation forecasts. Some officials believe an approach that would be more relaxed about allowing inflation to exceed 2% more often would signal the Fed’s commitment to taking bolder action to boost growth after a recession.
Any such change “is a way of essentially saying to market participants that rates will stay low for a very long time when a serious negative shock hits,” said former Fed Chairwoman Janet Yellen earlier this year. “That should promote a very rapid decline in long term rates, which will quickly provide stimulus.” This, in turn, should convince the public the Fed is serious about making sure it will meet its 2% inflation target.
In a speech Monday, St. Louis Fed President James Bullard said an interest-rate cut by the central bank “would be warranted soon” to help firm up inflation, particularly given recent rising risks to the U.S. economy from escalating global trade tensions. Mr. Bullard is the first member of the Fed’s rate-setting committee to signal support for a rate cut at a coming meeting.
The Fed says its current 2% inflation target is symmetric, meaning officials are as uncomfortable with inflation somewhat below as somewhat above that level. In other words, 2% isn’t a ceiling.
Chicago Fed President Charles Evans said in an April interview he wants officials to show they are willing to accept inflation running slightly above 2% more often to make the target more credible.
New York Fed President John Williams is proposing an even bolder step in which the Fed adopts an average inflation target, by which it would encourage inflation slightly higher than 2% during expansions to make up for below-target inflation during downturns. The current approach doesn’t take past performance into account: If inflation runs below 2%, the Fed doesn’t try to make that up in the future.
Supporters of Mr. Williams’s proposal say the Fed’s current policy doesn’t recognize how inflation fluctuates through economic downturns and recoveries. Because inflation is likely to run lower during recessions, particularly if short-term rates are pinned near zero, officials should seek to generate inflation slightly above 2% during expansions so that inflation averages 2% over time, the thinking goes.
Where will this end up? Several Fed officials have said they aren’t yet comfortable with making such firm, forward-looking commitments.
“It’s one thing to say, ‘I will take these things into account,’” Dallas Fed President Robert Kaplan said last month. “It’s another thing to commit to, in effect, a rule.”