Why is the Federal Reserve targeting 2% inflation over the longer term?

According to Federal Reserve documents, the Federal Open Market Committee (FOMC) considers inflation to be 2% over the long term, as measured by the annual change in the personal consumption expenditure price index (PCE), is most compatible 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 informed decisions about saving, borrowing and investing, which contributes to the good functioning of the economy.

For many years, inflation in the United States has been below the Federal Reserve’s 2% target. It’s understandable that the higher prices of essentials, such as food, gasoline and shelter, add to the burdens many families face, especially those struggling with loss of jobs and income.

At the same time, too low inflation can weaken the economy. When inflation is well below the desired level, households and businesses will expect it over time, pushing future inflation expectations below the longer-term inflation target. from the Federal Reserve. This can pull real inflation even lower, leading to a cycle of ever lower inflation and inflation expectations.

If inflation expectations fall, interest rate would also decrease. In turn, there would be less room to cut interest rates to boost employment during an economic downturn. Evidence from around the world suggests that once this problem sets in, it can be very difficult to overcome. To meet this challenge, after periods when inflation has been consistently below 2%, an appropriate monetary policy will likely aim to maintain inflation just above 2% for some time. By looking for an average inflation of 2% over time. The FOMC will help ensure that long-term inflation expectations remain firmly anchored at 2%.

In addition, the Fed has repeatedly stated that it will keep short-term rates close to zero and continue its monthly bond buying program until it sees not only a low rate of unemployment, but also an “inclusive” employment recovery by income, gender and racial lines.

Powell thinks the Fed has the tools to manage inflation

Generally speaking, we now know why the Federal Reserve wants to see inflation at 2%, but Powell and his policymakers want to allow inflation to rise above that mandated level until he is convinced that the economy is s he has fully recovered from the shock of the pandemic. This is what scared investors in March, but they have since calmed down with stocks hitting record highs.

Powell’s confidence in his ability to fight inflation may be responsible for the sudden surge in demand for stock prices and the apparent market acceptance of rising Treasury yields.

As inflation rises throughout 2021, there will be pockets of volatility as some investors will think the Fed is lagging behind in leaving its current policy of low interest rates and aggressive bond buying unchanged.

However, if he suspects that inflation is getting out of control, he usually looks to open market operations, the federal funds rate, and the bank rate to stem the inflationary surge.

Open Market Operations

The Fed’s first line of defense against soaring inflation is usually open market operations. In implementing this policy, it sells securities such as treasury bills to member banks. The movement reduces the capital of the banks, giving them less to lend. Essentially, it takes money out of the economy. As a result, banks raise interest rates and this slows down economic growth, curbing inflation.

Federal funds rate

The Fed funds rate is probably the Fed’s best-known tool. This is also part of its open market operations. This is the interest rate charged by banks for overnight loans that they grant to each other. It is a very easy tool for the Fed to use. Its purpose is to take money out of the economy and slow down inflation.

Discount rate

This is the interest rate charged by the central bank to member banks to borrow funds from the Fed’s discount window. Once again, the process of raising rates takes money out of circulation, reducing the money available for loans and mortgages. This helps to slow down economic growth or inflation.

Reserve requirement

The most powerful tool available to the Fed is the reserve requirement. The Fed has eliminated reserve requirements, effective March 26, 2020. This happened at the start of the COVID-19 pandemic. The last thing the Fed wanted during this critical time was for the banks to take money out of the economy.

Once the economy recovers and inflation hovers at or above 2%, the Fed has the power to tighten the reserve requirement rule that will force member banks to hold more capital in reserve. It is another tool that takes money out of the economy and thus reduces inflation.

Summary

Federal Reserve Chairman Jerome Powell and other Fed policymakers recently voted to keep short-term lending rates close to zero, while continuing an asset purchase program in which the bank Central buys at least $ 120 billion in bonds per month. Despite this decision, inflation remains below 2%.

T-bill yields have been rising rapidly for weeks as the market expects inflation to rise, which could force the Fed to change policy earlier than expected. The Fed says, however, that this will not be enough to change the policy which targets inflation above 2% for a period of time if it helps achieve inclusive full employment.

While some economists fear the Fed is inviting risks to the economy by allowing inflation to exceed the 2% mandate, Fed policymakers believe they have the weapons to control inflation and make changes fast enough to bring inflation down to 2% or below.


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