The Fed Must Attack Low Inflation
The U.S. economy remains weak, with inflation expected to remain below the Federal Reserve's target for years to come. When the central bank holds its policy-making meeting next week, it should take decisive action to end the malaise.
Charles Evans, president of the Federal Reserve Bank of Chicago, has suggested a good plan: Hold off on any further interest-rate increases until core inflation (excluding volatile food and energy prices) returns to the Fed's target of 2 percent "in a sustainable way." His thinking is that central banks know how to address high inflation (just raise interest rates) but have a much harder time dealing with inadequate inflation, so the Fed should place much more emphasis on avoiding the latter.
I would even argue that the Fed could do more. Evans's proposal, for example, does not contemplate unwinding the December 2015 interest-rate increase. Instead, the Fed could say that until its inflation target is met, it will maintain a zero rate on the excess reserves that banks deposit at the central bank (it currently pays 0.5 percent). It could add that it will consider reducing the excess-reserve rate below zero in order to accelerate the process.
Maintaining inflation near 2 percent is important because it provides consumers and businesses with certainty. It's like a yardstick -- if people are counting on it to be 36 inches long, being an inch short is as bad as being an inch over.
Borrowers and lenders, for example, need to know how much a dollar will be worth when the time comes to pay it back. Below-target inflation punishes borrowers by making it more expensive than expected to pay off their loans.
Persistently low inflation can also lead the public to expect more of the same. This makes interest rates look higher when the effect of inflation is taken into account -- a phenomenon that hurts the Fed's ability to help the economy by lowering rates.
Over the past three years, the Fed has focused on "gradual normalization," meaning slowly restoring interest rates to levels much closer to those seen historically. If, as Evans suggests, the Fed instead waits until core inflation reaches 2 percent, it will probably have to raise rates more quickly at that point -- a move that could cause turbulence in bond markets and unsettle investors. But this shouldn’t keep the Fed from adopting Evans’s plan: After all, investors' losses and gains are much less important than the health of the broader economy.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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