Since 2012, Fed policy has been to boost core consumer inflation to 2% -- with little success. Why does the Fed persist?
The world’s central banks added record liquidity to the world financial system in response to the devastating impact of the COVID-19 pandemic. Yet inflation in the U.S. has showed few signs of heading upward toward the Fed’s long-held 2% target for personal consumption inflation.
One factor motivating the Fed to continue pursuing this target is the need to prevent the U.S. economy entering a pernicious cycle of “debt deflation”,
According to Western Asset’s Amit Chopra:
“[Debt deflation] is where depressions occur, as the real value of debt rises due to deflation. This debt burden then leads to a cycle of defaults, drops in collateral values, and declines in lending activity and growth. The Fed also realizes that “an ounce of prevention is worth a pound of cure” and does not want to see the US come anywhere close to an entrenched period of deflation like Japan has experienced.”
(Excerpted from Inflation: Is 2% The Right Target?)
Core PCE Inflation, 2012 - 2020
Percent, as of 7/14/2020
Source: Bloomberg Finance LP. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
Chopra suggests that the Fed’s fear of a deflationary crisis may be overstated:
“We are a long way from deflation and it is not evident that low inflation drives lower real growth. Does 1.5% versus 2% inflation really impact consumer behavior, business investing and lending activity? Consumers likely cannot tell this small difference in price levels and businesses are more driven by inherent growth opportunities as opposed to marginal price differences.”
Given the lack of evidence that deflation is on its way, questions arise as to the ultimate impact of the current rapid addition to the world’s monetary base, the borrowing that makes it possible, and the financial asset price rises it may be causing. Whatever the longer-term result, caution and concern are likely to remain.
COVID-19 is the World Health Organization's official designation of the current novel coronavirus disease. The virus causing the novel coronavirus disease is known as SARSCoV-2.
Emerging markets (EM) are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries.
The Personal Consumption Expenditures (PCE) Price Index is a measure of price changes in consumer goods and services; the measure includes data pertaining to durables, non-durables and services. This index takes consumers' changing consumption due to prices into account, whereas the Consumer Price Index uses a fixed basket of goods with weightings that do not change over time. Core PCE excludes food & energy prices.
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