If you’re reading this article, it may be because you’ve recently heard about rising inflation. We can all recognize inflation as a phenomenon even if we aren’t familiar with the word “inflation.” We can see it at the gas pump, grocery store, and many other places.
While inflation is inevitable and part of a normal economic cycle, there is an ideal rate the Federal Reserve (the U.S. central banking system in charge of managing inflation) is constantly striving toward. Let’s dig into the ideal inflation rate and what the Fed does to get us there.
Key takeaways
- The ideal inflation rate is 2%. When inflation exceeds this figure, the Fed raises interest rates to slow down the economy for the next few months.
- The Fed has a dual mandate of keeping inflation low and employment high so that the maximum number of people are working in the country.
- When the Fed institutes aggressive rate hikes, it’s usually accompanied by widespread concern over an economic recession. The Fed has to walk a thin line, as recession only exacerbates affordability issues for the average American household.
Why Does Inflation Happen?
Before we look at the ideal inflation rate, we have to consider why inflation happens in the first place. In a perfect world, prices would be stable, and we wouldn’t have to worry about everyday purchases becoming painfully expensive quickly.
Generally, inflation occurs in two situations: limited supply or excess demand. If a specific part of the supply chain becomes more expensive, that can also lead to inflation.
To give you concrete examples, let’s consider events from recent years. This article is being published in 2023, a few years after the start of the COVID-19 pandemic. The pandemic interrupted supply chains, increased unemployment, and decreased demand for most goods and services. This brought the economy into a short recession in 2020.
However, when the government lifted pandemic restrictions and demand ramped back up, supply chains were slow to catch up. Gas prices, for example, rapidly rose when restrictions were lifted as producers struggled to readjust their operations to match demand.
The Russian invasion of Ukraine led to a Russian oil embargo, which impacted global energy prices. This event exacerbated the existing supply-demand mismatch, pushing energy prices higher.
Let’s consider a sector other than energy. Egg prices increased dramatically in 2022, partly due to the largest avian flu outbreak in U.S. history. Inflation isn’t always caused by unlucky, chance events, though.
Pandemic-era stimulus checks gave people more money to put into the economy. If individuals and businesses have more money or can cheaply borrow, this can increase demand and increase prices.
What’s the Ideal Inflation Rate?
What is the target inflation rate? According to the official website of the Federal Reserve:
“The Federal Open Market Committee (FOMC) judges that inflation of 2 percent over the longer run, as measured by the annual change in the price index for personal consumption expenditures, is most consistent with the Federal Reserve’s mandate for maximum employment and price stability. When households and businesses can reasonably expect inflation to remain low and stable, they are able to make sound decisions regarding saving, borrowing, and investment, which contributes to a well-functioning economy.”
The Fed tries to balance supply and demand since its dual responsibility is to maximize employment and keep prices stable.
Where Does the Ideal Inflation Rate Come From?
Four times yearly, the FOMC predicts how it expects the prices of goods and services to change over time. The FOMC believes long-term predicted inflation is the measure of inflation most consistent with stable economic prices.
Then, the FOMC decides what monetary policy to use to maintain the ideal inflation rate. The economy could face issues if inflation gets too low since there could be deflation. This means that prices and wages, on average, will fall.
However, some level of inflation indicates that the economy won’t likely experience deflation if economic conditions weaken.
While there’s an ideal inflation rate, there isn’t an ideal figure for the employment rates, as the FOMC hasn’t set an employment target. That said, the dual mandate of the FOMC is to maintain the maximum sustainable level of employment and price stability in the economy.
By keeping inflation down and stable, businesses can get into a consistent rhythm of utilizing their resources, leading to more stable employment numbers.
The FOMC has set an inflation target of 2%, measured in the annual change of the overall personal consumption expenditures (PCE) price index. This means that the Consumer Price Index (CPI) could be 2% monthly, and the Fed could still use monetary policy.
Additionally, the FOMC targets headline inflation instead of other measures. For example, due to volatility, core inflation strips the prices of food and energy from the index.
How Does the Fed Plan On Getting Us There?
The Fed can only control monetary policy by dictating interest rates. It decides on rates based on how the economy’s performing. Consequently, the FOMC has meetings in advance to discuss what will happen to interest rates.
The Fed raises interest rates over time until the economy cools off enough to get us to the ideal rate during high inflation.
They have to slow the economy down to restore the balance of supply and demand. In simpler terms, the Fed can increase the cost of borrowing money to decrease consumer spending. Softening demand can push prices down and help the economy stabilize.
Is it easy to get there? The short answer is no. It’s incredibly challenging to engineer a soft landing scenario involving raising interest rates enough to slow down the economy without putting it into a recession.
Rate hikes can often lead to a recession. Analysts will sometimes hope for a growth recession, where the economy continues to grow slowly while other symptoms of a typical recession – like higher unemployment – emerge.
What Data Does the Fed Consider?
What exactly does the Fed look at when deciding interest rate hikes or reductions? Here are some of the economic data points that the FOMC considers when making monetary policy decisions:
- Trends in prices and wages.
- Employment rates to see what’s happening with the labor market.
- Consumer income and spending.
- Business investments.
- Foreign exchange markets.
Sometimes one of these data points can paint a different picture of the economy from the others. For example, in 2022, many believed a strong labor market kept the U.S. out of a recession.
The FOMC meets eight times per year at regular intervals. Analysts and investors pay attention to each meeting to gauge where interest rates may go. Proactive investors will often go through the consumer price index (CPI) ahead of these meetings to anticipate the central bank officials’ decisions.
Does the Fed’s Plan Always Work?
Only sometimes. In 2022, for example, critics complained that the Fed waited too long to take action. The central banks initially felt inflation was transitory due to unique circumstances from the government lifting pandemic-related restrictions.
The original plan for the Fed was to create a soft loading, where the economy would slow down without going into recession. However, many skeptics argued the Fed’s delay made this situation impossible.
Generating a soft landing comes with the inherent dangers of rate hikes. With interest rates going up, unemployment numbers also tend to rise. When people are out of work, they have no money coming in. In turn, household spending decreases beyond the necessities.
When discretionary spending goes down, there’s no telling how far the drop in the economy could go.
Conversely, critics may also take issue with the Fed’s rate hikes not being aggressive enough. The biggest challenge the Fed faces is that there’s no exact timeline for when we can expect to see the results of each rate hike.
It’s also worth mentioning that historically, the Fed hasn’t been able to accurately set up a soft landing for the economy on command. Some argue we saw soft landings in 1965 and 1984.
What is Stagflation?
Don’t mix up inflation with stagflation, an economic situation much direr in which high inflation combines with high levels of unemployment. The last time the U.S. saw a period of persistent stagflation was during the 1970s. With stagflation, stagnant demand in a country’s economy makes escaping the situation much more difficult.
How Should You Be Investing?
It can be scary to stay invested during times of high inflation because of the market’s uncertainty and volatility. The fear of a recession alone is enough to lead to stock market sell-offs where even companies with strong financial results can suffer.
Reapportioning your portfolio to increase exposure to inflation-proof stocks can be a good strategy for saving money. Consider investing in businesses like grocery stores and energy companies or investment products like I bonds and REITs.
Final Words
Inflation is the devaluation of currency over time, usually caused by excess demand or limited supply. The Fed has a target inflation rate of 2%. If inflation rises above this rate, the Fed may raise interest rates to make borrowing money more expensive, pushing down demand and stabilizing prices. The Fed walks a fine line between managing inflation and keeping the economy from entering a recession.
If you’re an investor, there are options for you during inflationary or recessionary economies. Read some of our other articles to learn more about how you should invest during times of high inflation.
