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The Fed’s 2% Inflation Goal: Why Communication Matters

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Inflation is too low

The growth rate low rate of the PCE (personal consumption expenditure) price index, which is the US Federal Reserve’s favorite inflation measure, is Charles Evans’s main concern. Evans, the chief of the Chicago Fed, discussed monetary policy in London on March 25, 2015.

Whe central bank officials talk about inflation, they usually refer to the changes in the PCE price index. The US central bank is mandated to maintain this inflation level at 2% year-over-year in the long term. The Great Recession had pushed inflation far below that goal. PCE inflation has risen by just 1–1.5% in the past six years.

Charles Evans explained that a more popular measure of inflation, the CPI (consumer price index) generally is 0.25–0.50% higher than PCE inflation due to different calculation methods. Even this measure has been below 2% since 2008, although, as we’ve seen, it should be rising by ~2.5%.

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Why is achieving the inflation mandate important?

With an explicit target of 2%, the Fed has its goal cut out for it. And it’s important for officials to act according to persisting inflation levels because a consistent deviation could have a significant impact on the economy.

For example, when banks and lenders like Wells Fargo (WFC), Citigroup (C), Bank of America (BAC), and JPMorgan Chase (JPM), which make-up ~27% of the SPDR Financial Select Sector Fund (XLF), are issuing loans, they set interest rates taking into account expected inflation. If inflation runs higher than their expectations, which they used to set their interest rate on the loan, then their compensation for inflation falls. This effect would reduce the purchasing power of the money received by these lenders as interest on fixed rate loans.

On the other hand, if inflation runs too low, affecting wage growth, then a fixed-rate loan becomes burdensome on borrowers. This is because even though they signed up for a loan when inflation was high, they still need to pay the fixed monthly installment as per the older fixed rate—even though inflation has fallen since then. A slow or minimal wage rise further worsens the situation.

So it’s important for the Fed to clearly communicate and achieve its inflation objective.

What do Charles Evans and the Chicago Fed expect for inflation? Let’s look at that forecast in the next article of this series.

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