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04 Jul I’m confused about how the Fed handles inflation. Can you explain?
Photo: pixabay.comQ. One day the analysts are talking about the Fed lowering the interest rates and then the next day changing their opinion again. All this talk of the Fed’s expecting 2.2% inflation makes me wonder. The 2.2% number was set during the days of low inflation, near-zero interest rate, federal government surplus and sustainable federal deficits. None of those situations exist now. The federal government’s surplus has long ago disappeared and the deficits have crossed $1 trillion already. Is the 2.2% inflation expectation still realistic, or is the Fed just living in a la la land of unrealistic expectations?
— Consumer
A. Terrific question.
Inflation is of course top of many people’s minds.
Let’s get to it.
The Federal Reserve, commonly called the Fed, has a dual mandate from Congress to maintain maximum employment and stable prices, said Deva Panambur, a fee-only planner with Sarsi, LLC in West New York.
In other words, it’s to ensure that people are gainfully employed, and prices are not rising at a painful rate.
However, he said, carrying out this mandate is easier said than done because there are so many things, such as domestic politics, fiscal policy, pandemics and geopolitics that affect the economy, but are beyond the Fed’s control.
The Fed continually revises its strategy to carry out its mandate as effectively as possible, he said.
For years, the Fed believed that an inflation target rate of 2% was consistent with its dual mandate, and it formally announced so in 2012.
In 2020, the Fed made a major revision to its strategy, when it began targeting an average inflation rate of 2% over time, Panambur said. With this revision, the Fed indicated that it would tolerate periods of higher than 2% inflation to compensate for periods of low inflation.
“Currently, the Fed believes its monetary policy is making some progress towards its inflation goal but acknowledges that inflation is still elevated, which is why it has maintained interest rates at a two-decade high,” he said.
The factors you point out as inflationary are valid risks to bringing down inflation and if inflation is not curtailed the Fed will act as needed, he said.
“Fortunately, the Fed has improved its transparency and communication significantly over time so any action will be signaled in advance,” he said. “Keep in mind though, that while high inflation is troublesome, the Fed is as worried if not more worried about deflation ie. falling prices, a situation we were faced with during the financial crisis and during the Pandemic.”
A lot can be lost in translation when you follow analysts who follow the Fed and in turn try to best make sense of an ever-changing macro world, Panambur, said.
“Practical application of economic theory is not a perfect science and investment decisions based on short term macro analysis are highly unreliable,” he said. “As you extend the time frame you can draw some realistic conclusions and improve the odds of success for long-term investments.”
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This story was originally published in July 2024.
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