The Federal Reserve (Fed) builds inflation into our economy. Official Fed inflation policy states that the health of our economy depends on a specific amount of inflation, 2 percent a year the “ideal” figure. That doesn’t seem like much, but run the numbers. With 2 percent inflation every year for 10 years, $1,000 drops in value to $817.07 losing $182.93. Inflation will never be consistent at 2 percent for each of the 10 years, but the Federal Reserve aims to keep that as the average and worries when it gets too high or too low. More about that in a minute.
The Fed enshrined that 2 percent policy in 2012 making it the standard for saving us from monetary disaster. That’s the goal, 2 percent, but why 2 percent? Explained St. Louis Fed President James Bullard in a January 16, 2019 paper by the St. Louis Fed, “To clarify, this does not mean inflation must be 2 percent in the short term; rather, monetary policy should be set so that inflation moves toward the target over time and, in the absence of unpredictable changes in either supply or demand, would reach 2 percent in the medium term.”
That still doesn’t answer the question. Why not 0 percent, 1 percent, or 3 percent? One of the Fed’s most important mandates along with low unemployment is to maintain stable prices. And 2 percent does that how? One way is by keeping inflation from being “too low.” Jerome Powell, current Fed chairman finds too-low inflation concerning. Too-low inflation can result in deflation, and they just can’t let that happen. Deflation can devastate the economy, they say, because people put off buying or don’t buy at all. If prices drop, people put off purchases waiting for prices to drop further. Thus, if say a 60-inch smart TV’s price drops to $700, people in the market for one might just wait for the price to drop to $650, and when it does, to avoid paying “too much,” wait again until it drops to $600. Spread that through the entire economy and slower sales in all categories can result in businesses laying off workers thus driving up unemployment, Powell warns.
The last time this country went into a “deflationary spiral” occurred in 1954 during the 1953- 1954 Post-Korean War Crisis when prices deflated, going down below zero to a minus-.07 percent. Coincidentally, that also marked the time when the Dow returned after 25 years to its 1929 high. The panicked Fed for the first time in history intervened and initiated a Federal Funds rate of 1.25 percent. Ever since, the Fed has seen to it that the inflation rate never again drops into negative territory.
Why did it pick that 2 percent figure? Not from any research, but just from a side comment by the New Zealand Finance Minister Don Brash in September of 1988. He commented in a TV interview that he thought the maximum inflation target should be 2 percent. Why? he never said. It was just his idea and opinion, supposedly from careful reasoning, but if he had a reason, he never let on what that reason was. Nevertheless, that 2 percent figure stuck in the notions of economists with the Fed and other bastions of economics ever since.
In 1996 becoming unofficial policy and in January 2012 written–in-stone, it still leaves unanswered the question of why that 2 percent figure, or any specific figure. Explanations run the gamut from speculation to monetary policy.
With monetary policy, the reason they most often pulled out in defense, the 2 percent figure gives the Fed room to move the federal funds rate up and down without dropping into negative territory, a territory where banks would have to charge saving account holders to have savings accounts. Sweden’s central bank used them first when in July 2009 the Riksbank cut its overnight deposit rate to -0.25 percent. The European Central Bank (ECB) joined the club in June 2014 when it dropped its deposit rate to -0.1%. Other European countries and Japan have imposed negative interest rates since, resulting in $9.5 trillion worth of government debt carrying negative yields in 2017. That didn’t go over well with governments and savers.
But still, a question still remains, why 2 percent, or even one percent? Apparently there is no concrete reason. It’s just that the Fed decided on that figure because it was as good as anything and some Finance Minister in New Zealand suggested it once in passing.
Far from an accurate measure of the cost of living, the official inflation rate measures prices selectively. The Bureau of Labor Statistics calculates the inflation rate by taking the Personal Consumption Expenditures (PCE) and dividing it by the Gross Domestic Product (GDP). What’s not included in the PCE and thus the inflation figures are food and energy. Thus, food prices might increase by 10 percent and gasoline by 20 percent, for example, and the inflation calculation won’t include those. In February 2023, food prices had increased by 10.2 percent over February 2022’s prices while the official inflation figure measured five percent over the same period. At the same time, gas prices rose exponentially as we see every time we drive past a gas station. Still those price increases are left out of the official inflation numbers. The reason, claims the Bureau of Labor Statistics: food and gas prices are too volatile,.
In the meantime, inflation affects people’s purchasing power. Some wages have kept up with inflation while others have dragged behind. The big winners, if you can call them that, are low-paying jobs. With labor shortages in leisure, hospitality, and other service industries, employers have resorted to offering higher wages. Industries with higher average pay have done the opposite. For example, the BLS reported in March average pay for new hires fell 9 percent in insurance, 8 percent in real estate, 5 percent in finance, and 15 percent in information, including technology. Employees in other industries have fared even more poorly. Gusto, a payroll processor for small businesses, reports that advertised salaries for Class A truck drivers fell 33 percent, for landscapers 44.5 percent, for customer service specialists 21.3 percent, for surgical nurses 5 percent, and for delivery drivers 4.5 percent.
Overall wages were up 5 percent year over year in March, just keeping up with the rate of inflation that dropped to 5 percent in March. That worries the Fed, which now may decide that they have to keep raising interest rates so wages fall behind inflation once again resulting in higher consumer debt because people have to use credit cards and other debt to pay monthly expenses such as food and gas, items not even included in inflation figures.
Inflation continues while the Federal Reserve keeps raising interest rates, wages can’t keep up because of the rise in interest rates, and inflation means consumer debt creeps up. That 2 percent inflation target looking pretty good in comparison, still eats into our earning power just not so much.
