I DON’T ENVY THE FOLKS in Washington. Last year, many accused Federal Reserve policymakers of being asleep at the wheel as they downplayed the risk of rising inflation. This year, of course, it’s been the opposite: The Fed has been in overdrive, raising interest rates aggressively. So far, the Fed has pushed through six increases in a row, totaling 3.75 percentage points. Many are now criticizing the Fed for moving too quickly.
This is in contrast to the challenge the Fed had been dealing with before COVID. For most of the past decade, it had been contending with a different problem entirely—inflation that was too low.
Read each of the Fed’s press releases, and you’ll see how policymakers think about inflation: “The Committee is strongly committed to returning inflation to its 2 percent objective.” It’s hard to believe today, but between 2009 and 2020, raising inflation up to that 2% mark was the challenge. Over that period, inflation averaged just 1.5%.
A popular online meme depicts the challenge the Fed is facing: A fellow puts a pot on the stove, turns on the heat and begins to cook his dinner. Everything seems fine. But within seconds, flames shoot up, and the man runs for safety. It’s funny, but it illustrates the box that Fed officials find themselves in: The central bank wants some inflation but not too much. It’s a tricky balance.
Given the risks posed by inflation—including the risk that it can flare up so quickly—many have asked why the Fed would want any inflation at all. Instead of its 2% target, why wouldn’t the Fed simply target zero? In simple terms, why should milk, eggs or anything else necessarily cost more each year?
There are two main explanations. First, a little bit of inflation helps keep the economy moving forward. This is easiest to understand if we look at the risk posed by deflation—that is, when prices are falling. Suppose you’re a consumer looking to make a major purchase—a new car, for example. In a deflationary environment, you could expect the price of that car to be lower in the future than it is today, so the incentive would be to delay that purchase. If you could hold off and get a better deal, you’d be rewarded for waiting.
That’s the dynamic that takes hold when there’s deflation. When consumers expect prices to fall from year to year, they’ll tend to postpone purchases. If enough people do this, economic growth can stagnate. Policymakers live in fear of this. Some feel that deflation is even worse than inflation.
That explains why deflation is a bad thing, but it still doesn’t explain why some inflation is necessary? Why wouldn’t the Fed simply target a zero-inflation rate, which would be neither inflationary nor deflationary?
In theory, a zero-inflation target might work, but it turns out that a little bit of inflation is still better than none. If consumers know that prices will generally be trending upward over time, that’ll nudge them toward making purchases today rather than tomorrow, when prices might be a little higher.
Another way in which a little bit of inflation helps the economy keep moving: When consumers have an expectation that their wages will rise over time, that makes them more willing to take on debt, enabling them to make major purchases.
Consider a young couple buying their first home. For a lot of people, it’s a financial stretch to make that first purchase. There’s the expression, in fact, that the first mortgage payment is the hardest. But people still take that leap of faith, because they have confidence their incomes will rise over time. For many people, mortgage payments feel slightly overwhelming at first. After several years, though, the payments feel manageable. And by the end—after many years of wage increases—the payments seem almost negligible.
If, however, home buyers had no expectation that their wages would rise over time, they’d be a lot more cautious. Imagine taking on an obligation that would feel slightly overwhelming not just in the beginning but for the entire 30-year period. Very few people would sign up for that. But because people expect their incomes to grow over time, they’re happy to take that risk. The Fed knows this, and that’s a key reason it targets an inflation rate that’s modestly above zero.
Beyond the benefits for the broad economy, there’s a second, more subtle reason the Fed prefers some inflation. Because interest rates and inflation are connected, the Fed always wants a little bit of inflation so it can maintain interest rates that are—ideally—in the low single-digits. That’s important because it gives the Fed the flexibility to drop rates when it needs to. When the economy goes into recession, that’s one of the Fed’s key policy levers to help reignite growth.
If rates are already low, however, that lever becomes much less effective. This problem isn’t just theoretical. One of the criticisms of former Fed Chair Alan Greenspan was that he left rates too low for too long after the 2001 recession. In fact, years after the recession ended, Greenspan’s Fed continued to lower rates. By mid-2004, the Fed had dropped rates to levels not seen since the 1960s.
While the Fed did finally begin to raise rates in 2004, they were still quite low when the next crisis rolled around in 2008. When the economy went off a cliff that year, the Fed faced a problem: With rates already low, Fed officials had little room to maneuver. As a result, they were forced to use the Tommy gun of monetary policy, known as quantitative easing (QE). When you hear about the Fed “printing money,” that’s what QE is all about.
The Fed employed QE in 2008 and again in 2020 because, in both cases, rates were already at very low levels. There’s no question that QE is effective, but it’s also a strategy of last resort—used when the Fed has no remaining room to drop rates. QE isn’t great because it’s risky. Dropping new dollars into the economy can exacerbate inflation, as we’ve experienced this year.
In reality, there’s an even more extreme policy option: The Fed could follow the lead of Western Europe’s central banks and push rates down below zero. In that case, the Fed could maintain an inflation target even lower than its current 2%. But negative rates open up another Pandora’s box. Among other problems, it means that savers are punished for saving. When you “earn” a negative interest rate, you actually have to pay the bank to hold your money, rather than the other way around. Because the consequences of this unusual policy are hard to predict, the Fed has so far stayed away from it.
The upshot: The Fed’s first choice during recessions is to employ the most traditional form of monetary policy—lowering interest rates—and thus that’s the second reason the Fed continues to walk a tightrope between an inflation rate that’s too high and one that’s too low.