An Urban's Rural View

How Much Inflation Will the Fed Tolerate?

Urban C Lehner
By  Urban C Lehner , Editor Emeritus
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The pandemic dampened travel for several months but now as more people take to the air again, airline tickets have also soared. Other goods and services are also expected to rise. (DTN photo by Elaine Shein)

In 2012, the Federal Reserve did something it had never done before. It announced an inflation target. Today, with inflation on the rise, the Fed is being asked some big questions about that target.

In its 2012 policy statement, the central bank said it would strive for 2% inflation, the rate "most consistent over the longer run" with achieving its Congressional mandate. That mandate calls for the Fed to promote "maximum employment, stable prices and moderate long-term interest rates" -- three goals that can sometimes conflict. (https://www.federalreserve.gov/…)

From 2012 until very recently, inflation was below 2%. The undershoot went hand in hand with slow growth, producing what the Fed called "shortfalls in employment." Some economists feared the U.S. was falling into the deflation trap that has long ensnared Japan.

Last August, the Fed reacted by tweaking the 2% target. "Following periods when inflation has been running persistently below 2%," the Fed said, "appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time." (https://www.federalreserve.gov/…)

Now that policy tweak is being tested. Last month, consumer prices rose 5.4% from a year earlier following a 5% increase the month before. In testimony before Congress, Fed chair Jerome Powell has confirmed that this was not what the central bank had in mind. "Inflation is not moderately above 2%. It's well above 2%," he said. "It's nothing like 'moderately.'" (https://www.wsj.com/…)

What Powell didn't say was how Fed policymakers define "moderately." We can deduce it's somewhere between 2% and 5%. But where? How much inflation is the Fed willing to tolerate?

The answers matter to investors and consumers. They matter especially to farmers, ranchers and other businesspeople who borrow operating money. For once the Fed becomes convinced it needs to do something about inflation, the result will be tighter money and higher interest rates.

With inflation running as hot as it's been in recent months, you may wonder why the Fed hasn't tightened monetary policy already. The reason is straightforward: Fed policymakers think today's inflation is transitory. It's being driven by temporary factors that will soon at least partially reverse. For now, the Fed is watching the data to see how far above the 2% target inflation finally settles.

Some of the drivers of inflation are indeed probably temporary. New and used-car prices are up sharply, in part because of a worldwide shortage of computer chips that will eventually end. Prices of airline tickets and hotel nights have also soared, but that's because they're rebounding from steep falls during the pandemic.

But for some goods and services, prices could continue to rise. Take restaurant meals. They're costing more because fewer workers sought restaurant employment during the pandemic. (https://www.wsj.com/…)

Owners have had to raise wages and prices have gone up to compensate. As pandemic panic recedes, the labor shortage might end. Then again, it might not. In a rebounding economy, more desirable jobs are available. McDonald's is committing millions to wage and benefit increases because its restaurants are struggling to hire workers. (https://www.wsj.com/…)

Inflation hawks fear the Fed will wait several months, only to discover that inflation continues at a rapid pace. The central bank will then find itself behind the curve.

Another fear: The self-fulfilling prophecy of inflationary psychology. Expectations of higher prices lead to higher wages, which in turn spawn further price increases -- and soon inflation is spiraling out of control. There are already signs of those expectations developing, though it's unclear how seriously these signs should be taken. (https://www.wsj.com/…)

In the Fed's defense, two things can be said. One is that an unemployment rate of 5.9% in June suggests there's still plenty of slack in the economy. While much improved from the 14.8% level in April 2020, joblessness is still well above February 2020's 3.5%.

The other, more important thing is that the bond market seems unconcerned. The yield on the 10-year Treasury bond has fallen in recent months to 1.3% from 1.7%. No one cares more about inflation than bond investors and if they were worried, interest rates would be rising, not falling.

Waiting awhile before tightening makes sense, then. So does issuing warnings that the Fed won't hesitate to raise rates if needed, as Powell did in his congressional testimony.

In the months ahead, the world will continue to wonder how the Fed will define "moderately above 2%?" Will the Fed tolerate a prolonged spell of inflation higher than 3%? Or 4%?

Much rides on the answers. Stand by.

Urban Lehner can be reached at urbanize@gmail.com

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