The Fed Gambles on Inflation

Over the past couple of decades, the Federal Reserve has coalesced around an idea about inflation that is little more than theoretical, with no real data to back it up. That "idea" is that 2% inflation is the "correct" amount of inflation.

The target is not just a one-year target, it is seemingly a permanent, long-term target. We find this idea very problematic. For example, the Fed's favorite measure of inflation, the PCE deflator, has averaged 1.5% over the past decade. But the Fed now says it could let inflation in the future run high so that the long-run average rises to 2%. No one knows exactly what this means, but one interpretation is that the Fed is willing to have inflation run at 2.5% for the next ten years so that the 20-year average is 2%.

Really? Why? If we look back over the past ten years, low inflation didn't hurt the economy, it helped it. Unemployment had fallen to 3.5% in February, the lowest since the 1960s. Yes, we know we're just emerging from the problems related to COVID-19, but that's an outside shock to the economic system, not something monetary policy can plan for ahead of time. It had nothing to do with the Fed or the level of inflation.

We have always believed that the underlying reason for the existence of the Fed was to maintain a stable value of the dollar. The most stable environment is one with no inflation. As Steve Forbes has always said, if a carpenter shows up at a job site and his yardstick is a different length than it was the day before, it is awfully hard to build a house, maybe impossible.

The same is true for the value of the dollar. It's far more complicated to make an investment, build a plant, or sell goods to a foreign country if the value of your currency changes over time making the value of revenues and investment change with it.

This is what worries us about the commitment to 2% long-run inflation. No one knows exactly what it means, or for that matter, why it is appropriate. Again, inflation averaged 1.5% over the past ten years with no serious consequences to the economy. By allowing inflation to average 2.5% over the next ten years, how does that change the past? The answer: it can't!