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Why the Fed may regret targeting low inflation

May 28, 2014

| MoneyRates.com Senior Financial Analyst, CFA

The Federal Reserve is worried that inflation is too low. People with money in savings accounts and other deposits should be worried too -- but more about the Fed's intentions than about low inflation.

In the statement following its most recent meeting, the Federal Open Market Committee expressed concern over the low recent levels of inflation. Another recent piece from the Federal Reserve Bank of Cleveland explored why it considers low inflation to be a problem, and what some possible solutions might be.

Why consumers may not agree

To most American consumers, and to anyone with savings accounts yielding virtually no interest, low inflation has not been a problem -- it has been the one saving grace of the weak economy. Here are some reasons why the Fed's apparent longing for higher inflation may be misguided:

  1. Disinflation is not deflation. The Cleveland Fed acknowledges that we have been experiencing a slowing rate of inflation, or disinflation, rather than an actual downturn in prices, or deflation. The difference is significant. While deflation can worsen economic malaise by causing people to delay purchases in hopes of lower prices, disinflation is more a symptom of existing economic weakness than a cause of further weakness.
  2. Consider the sources of low inflation. The Cleveland Fed points out that two major sources of slowing inflation have been energy prices and health care costs. However, this follows an extended period in which price increases in these sectors were above overall inflation, so a slowing of these price spirals is welcomed by most consumers.
  3. It is important for wages to rise before inflation. Another source of low inflation has been weak wage growth, and this is a real problem. However, the Fed already has a target of lowering the unemployment rate, and the economy is making progress toward that goal. Lower unemployment will help support higher wages. It is important that wages start to grow before inflation in general does, or else American workers will find themselves still going backward economically.
  4. Stimulative policies have side effects. The Cleveland Fed suggests that more asset purchases and a longer commitment to a near-zero federal funds rate may be the answer. These policies have helped fuel a possible bubble in stocks, and the near disappearance of interest on savings accounts. More of the same is not desirable.
  5. Inflation can be difficult to contain once it gets going. Inflation can become an upward spiral of prices that is tough to end once it starts. The Cleveland Fed acknowledges that when inflation got out of hand in the 1960s and 1970s, it took a deep recession in the early 1980s to subdue it. The Fed may regret poking this monster once they wake it up.

As a huge debtor, the federal government has a significant interest in feeding inflation: Rising prices erode the value of existing debts. But anybody who is a net saver rather than a debtor may just find themselves on the wrong side of the Fed's agenda as a result.

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