Jul 31, 2019

Why the Fed wants higher inflation

Illustration of a dollar bill being cut with scissors

Illustration: Rebecca Zisser/Axios

Low inflation may sound good to consumers, who like what it suggests about the prices they'll pay. But the Federal Reserve — which will likely cite the lack of meaningful price increases as a motive for cutting interest rates today — has reasons for concern.

Why it matters: Inflation has come in below the Fed's "sweet spot" — 2% inflation — throughout much of the record-long economic expansion, and consumers have benefited from low prices accompanied by low borrowing costs. But Fed chair Jerome Powell has pivoted to warn of the dangers of weak inflation — a shift from the more common fear of rising inflation, like the type of soaring prices seen in the late 1970s and early '80s.

What they're saying: Significantly lower prices for consumers can translate to shrinking profits for businesses. These businesses may then have to cut workers' pay or lay them off to make ends meet.

  • "When you go to a store and you see lower prices, that's great, but what are those lower prices driven by?" Beth Ann Bovino, S&P Global's chief economist, tells Axios. "If lower prices are because businesses have a much more productive way of making that product, then that's great."
  • But prices falling too rapidly is bad for businesses, which are usually locked in to costs, and could lead to a spiraling effect. "That means they have to let go of workers," Bovino says. "Workers no longer have their paychecks anymore, unemployment goes higher."

Background: In theory, with unemployment this low and a shrinking pool of available workers, companies should be bidding up wages to attract employees, thus igniting inflation. But that dynamic hasn't played out as it has in previous economic cycles.

The Fed's preferred measure of inflation came in at an annualized pace of 1.6% in June — below the 2% target, though a rebound from prior months. Indeed, the Fed "has failed to convincingly reach the goal" since formally adopting its inflation policy in 2012, despite already low interest rates, as the Wall Street Journal points out.

  • While it may seem like a slight miss, the Fed is concerned that low inflation will cause expectations for inflation to fall even further.
  • That would make it more difficult for the Fed to step in and cut interest rates in an effort to push inflation higher, leading to a deflationary environment.
  • "We’ve seen it in Japan. We’re now seeing it in Europe. ... That road is hard to get off," Powell told Congress earlier this month.

The fear of higher inflation may feel like more of a risk, because it's more recent in consumers' memory. By contrast, the last deflationary period in the U.S. was in the 1930s.

  • But "deflation is more painful for the economy and for individuals than inflation," Nathan Sheets, a former Fed official and current economist at PGIM, tells Axios.
  • "When you're in a period of deflation, what it's doing is it's sucking down the power of prices. Wages are falling and prices are falling. A deflationary environment tends to transfer resources from debtors to creditors," says Sheets.

The bottom line: Economists are wary that a 25 basis point cut — which many people expect the Fed to announce today — will be enough to trigger the type of inflation the Fed wants to see in order to prove that its 2% target is not, in fact, a ceiling.

  • Chicago Fed president Charlie Evans, a voting member of the Fed's rate-setting committee, said this month that on the "basis of inflation alone, I could feel confident in arguing for a couple of rate cuts before the end of the year."
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