The Federal Reserve has the dual mandate of price stability and low unemployment. It seems to have achieved both of these goals recently, with low inflation and low unemployment. However, the fact that inflation has been below the Federal Reserve's target even as unemployment has reached levels consistent with an economy functioning at full employment is somewhat of a mystery. It may be that inflation is responding slowly to economic circumstances and that as the labor market continues to tighten, wages will start increasing and prices will follow.
On the other hand, low inflation could reflect an economy weaker than what the unemployment rate would lead us to believe, perhaps because low unemployment is partly reflecting low labor force participation of both men and women in prime working ages -- which reduces the unemployment rate.
These market-based indicators are, however, imperfect measures of inflation expectations, as they combine true expectations for inflation with a risk premium —compensation that investors require to hold securities with value that is susceptible to the uncertainty of future inflation. The easiest way is to use its monetary policy tools to achieve and maintain inflation around 2 percent.
However, the Fed can also influence expectations with its words, particularly by elaborating on how it intends to use its monetary policy tools in the future to achieve the 2 percent goal. To this end, in August , the Fed modified its monetary policy framework. It is sticking with its 2 percent inflation target but now says that it intends to offset periods of below-2 percent inflation with periods of above-2 percent inflation, an approach it is calling Average Inflation Targeting AIT.
In its old framework, if inflation fell below the 2 percent target, the Fed pledged to try to get it back to target without compensating for the period of inflation shortfall.
The change makes explicit that, following a period in which inflation has fallen short of target for a time, the Fed will accept and even encourage periods of above-2 percent inflation going forward, discouraging a decline in inflation expectations.
When inflation expectations are anchored at target, it is easier for the Fed to steer inflation to 2 percent. If inflation expectations move down from 2 percent, inflation could fall as well—a reverse wage-price spiral. In the extreme, this process can increase the risk of deflation, a damaging economic condition in which prices fall over time rather than rise.
Another reason that the Fed worries about low inflation expectations is that they are closely related to interest rates. When setting prices on loans, lenders and investors account for the expected rate of inflation over the life of the loan. Nominal interest rates are the sum of the real interest rate that will be earned by lenders and the expected rate of inflation.
When nominal interest rates are very low, as they are now and are projected to be in the near future, the Fed has less room to cut interest rates to fight a recession. Because higher inflation leads to higher interest rates, people will generally want to economize on the amount of cash that they carry in order to leave more of it in the bank where it can earn interest. Consequently, people will incur the cost of more trips to the bank.
Borrowers and lenders Interest rates specified in loan agreements typically incorporate a component based on the expected rate of inflation over the length of the loan. If inflation turns out to be higher than expected, then the debtor benefits because the repayment adjusted for inflation turns out to be lower than what the two parties anticipated.
If inflation turns out to be lower than expected, then the creditor benefits because the inflation-adjusted repayment will be higher than what was anticipated by both parties. Consequently, unanticipated inflation transfers wealth across borrowers and lenders arbitrarily. Savings and investment decisions. When inflation becomes less predictable, then both consumers and firms will face greater uncertainty. Because the decisions of consumers and firms depend on their view of future conditions, greater uncertainty can cause them to alter their plans.
For example, higher uncertainty about future inflation will also extend to greater uncertainty about interest rates, wages, taxes, and profits. In response, businesses may delay or postpone hiring decisions and expenditures on new buildings and equipment, while households may cut back on consumption and save more.
Both of these types of responses can lead to reduced spending and lower activity in an economy. Relative price changes.
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