Some would argue that 2% inflation is not just a Fed goal, as it strives to contain the pandemic-related price increases that have plagued American households for the past three years.
It is the Fed’s holy grail, guiding principle, and mantra.
But these days, the 2% target feels more like an economic Godot. A solution to the inflation problem, which until recently seemed tantalizingly close, now appears even further away, raising questions about whether it will ever be achieved.
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This dilemma could have significant implications for consumers, investors, and the U.S. economy. Fed officials have said they won’t begin cutting rates until inflation is “sustainably moving toward” its 2% target. A rate cut would lower borrowing costs for millions of Americans, boost economic growth and further strengthen the stock market.
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But as the economy shows early signs of stagnation, some top forecasters are increasingly asking some version of this question.
What’s so magical about 2%?
And does the Fed really need to wait until inflation approaches its seemingly hallowed target to begin lowering its key interest rate, which has hovered at a 23-year high since last summer?
“I don’t think 2% is the right number,” said Mark Zandi, chief economist at Moody’s Analytics. “Don’t sacrifice the economy to change the 2% target,” he said.
Other forecasters say the Fed has no choice but to stick almost religiously to its 2% target, hoping that consumers and businesses will do what the Fed says and that annual price inflation will actually fall to 2%. If people don’t expect inflation to slow to 2%, that could itself keep inflation rising.
Jonathan Miller, senior U.S. economist at Barclays, said if the Fed hits its target, “the worry is that we’ll lose credibility.”
Where did the 2% inflation target come from?
The Fed raises its key short-term interest rate to raise borrowing costs and cool the economy and inflation. Lower interest rates on credit cards, mortgages, and other loans to accelerate growth.
New Zealand was the first country to adopt a 2% inflation target in the late 1980s. The Fed informally adopted the benchmark in the mid-1990s, but did not formally announce it and make it part of its policy until 2012. Many other developed regions, including Europe, Japan and Canada, have 2% inflation targets.
In the decade following the Great Recession of 2007-2009, annual inflation mostly languished below 2% as the crisis’s glacial recovery took hold. By 2019, the Fed had tweaked its target, saying it would aim for inflation to average 2% over the long term, while allowing it to run a little above target for a while to make up for periods when it missed the target.
Officials hoped it would help shake up the struggling economy.
How has the pandemic affected inflation?
The pandemic rendered new approaches moot, and the country’s recovery from the pandemic has triggered rapid growth with inflation soaring to a 40-year high. In response, the Fed raised the federal funds rate from near zero to a range of 5.25% to 5.5%.
Last year, the Fed’s preferred core inflation rate, which excludes volatile food and energy items, plummeted from about 5% to 3% as pandemic-related product and labor shortages largely subsided. Fed officials expect three rate cuts in 2024, and the stock market is expected to reach record highs.
However, since December, the price index has been stuck at 2.8% to 2.9% as inflation has heated up, putting a damper on the market rally. Last week’s improved but still not great inflation report buoyed investors, with the Dow Jones Industrial Average closing above 40,000 for the first time on Friday.
Most economists and futures markets now expect the Fed to cut rates once or twice this year.
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What will inflation be like in 2024?
Here’s the problem. If monthly price increases slow to a more typical 0.2% from the recent 0.3% to 0.4% range, as many economists expect, annual inflation would remain at 2.9% by the end of the year, Miller said. is estimated. On top of that The reading in March was 2.8%. This is because monthly price increases slowed significantly in the second half of 2023, widening the gap between price levels a year ago and expected prices in the second half of this year.
Does that mean interest rates will remain the same?
necessarily. Fed Chairman Jerome Powell said inflation doesn’t need to be 2% for officials to start cutting interest rates, as long as inflation continues to move in the right direction. Even if annual inflation remains high, a gradual decline in monthly price increases of 0.2% over the next few months could be enough for the Fed to cut interest rates once in September, Miller said. Ta.
But it won’t take long to reverse even the intermediate scenario. According to Gregory Daco, chief economist at EY Parthenon, if monthly price increases average 0.3% for the rest of the year (just a fraction higher), the annual inflation rate through December would be a whopping 3.8%. It will be. In that case, we cannot expect the Fed to cut interest rates in 2024.
What is causing high inflation?
Only a few products and services continue to experience inflationary increases.
According to one inflation measure, sustained increases in housing costs account for 36% of monthly price increases. While rents fell for tenants who signed new leases, the changes were slow to trickle down to existing leases. And if the exotic and controversial measure of single-family home rents were removed from the Fed’s preferred price index, inflation would already be below 2%, Zandi said.
And even as new-car prices slumped amid a pandemic-induced price surge, auto insurance rates rose 23% annually in March as state regulators take longer to approve insurers’ proposed rate hikes. But smaller increases or decreases should follow.
The cost of financial services has risen sharply due to soaring market prices, and fees charged by investment companies, which are determined based on the percentage of assets under management, are increasing.
These cost projections are unaffected by interest rates and should not cause the Fed to keep rates high, Deko said.
Miller disagreed, saying high borrowing costs could hurt hiring, delay raises in other industries such as auto repair and haircutting, and drag down overall inflation.
Is the U.S. job market good right now?
Fed officials said a strong economy, with average monthly job growth of 245,000 jobs this year, and a still strong labor market mean they can afford to wait for inflation to ease before cutting rates. ing.
However, Zandi and Daco are showing signs of decline. Only 175,000 jobs were added in April. And while net monthly payroll increases have been strong this year due to fewer layoffs, employment and job change rates are below pre-pandemic levels. The underlying indicator of retail sales declined in April. And low- and moderate-income Americans are struggling with record credit card debt and historically high delinquencies, Zandi and Daco say.
With the economy unstable, “something could break,” Zandi said. “Why seize the opportunity” by keeping interest rates high?
Is 2% an appropriate inflation rate?
Zandi argues that the 2% inflation target is no longer relevant. He said that with the economy’s potential growth rate lower than in the 1990s, the Fed has allowed 3% inflation in order to raise long-term interest rates and give officials room to cut rates before they hit zero in the event of a recession. argued that it should be done.
And Mr. Darko advocates allowing some wiggle room around the 2% target to give the Fed more flexibility to respond to unexpected economic developments.
Should the Fed raise its inflation target?
Here’s the problem.
Miller said the Fed cannot adjust its 2% inflation target because that would “significantly undermine” the “credibility of the target.”
He said the public would think they would “throw in the towel” just because it became difficult to reduce inflation. Miller says that based on his belief that inflation will remain high, workers will demand larger wage increases and businesses will raise prices more sharply, perpetuating high inflation.
Many investors are also buying bonds that yield slightly above inflation in hopes that the Fed will keep inflation at 2%. If the central bank changes its targets, he says, “it’s like breaking a contract.”
When can we expect the Fed to lower interest rates?
But when the Fed lowers rates is a deciding factor. Powell said if the labor market weakens unexpectedly, authorities could cut interest rates even if inflation remains high. Zandi and Daco think that’s already happened.
Darko believes the Fed will start cutting rates in July. “Only time will tell” whether a September cut means the Fed waited too long and sparked a recession, as the market expects, he said.
In other words, the Fed can’t officially change its inflation target, but it could err on the side of lowering rates too early, knowing that the target doesn’t need to be as stringent, Zandi said. Mr. and Mr. Dako say.
Don’t hold your breath.
In his press conference, Chairman Powell flatly rejected any suggestion that the Fed might be satisfied with inflation above 2%. This month, he said: “Of course we are not satisfied with 3 percent inflation.” You cannot put “3 percent” in a sentence that includes “satisfied.” ”