Raised Neutral Inflation Rate

The neutral rate of inflation has been determined by policymakers at 2% and formalized in 2012 (CITE Furman). This number is simply a target for where inflation should try to be kept, with the likely possibility of the number varying above or below the target rate. In the past year we have seen the Fed trying to lower this figure by increasing the interest rates, and while the difference has closed, they are still attempting to return inflation back to the 2% target rate. Here comes the question of tolerance. How much more can Americans tolerate the interest rates being at the rates they are at now? Is the Fed pushing too much to try to reach the 2% mark at the expense of jobs and the risk of recession, which is really just a made up target rate decades ago? What if we let go of that 2% target rate idea and instead opted for allowing the inflation rate to settle slightly above it? If this does become the case, it is important for the Fed to be confident in their
decision, “shifting to a higher inflation target in a manner that wasn’t credible could disrupt these expectations, leading to soaring inflation premiums for borrowers, driving up government’s deficits, and reducing private investment” (CITE Furman). This is not to say that the Fed should just forgo the 2% rate, moreso that reality has changed since this target was set and that a shift to a slightly higher target rate is not something that is out of the question. It is in everyone’s best interest for inflation to stay at bay with hope that the Fed makes the right decision for that to happen in these next coming months.

Disinflation Prior and the Possibility of Inflation Lowering

We know that inflation needs to be lowered, so other important areas to look at are disinflation and also deflation. Disinflation is when inflation is still rising, just at a slower rate than prior. It is imperative to avoid deflation because although the sound of prices decreasing may sound nice, it actually means that the economy is weakening. One example of deflation that occurred was in the 1920s, “a collapse in aggregate demand and credit channels, along with policy mistakes,
drove deflation of the late 1920s and early 1930s” (Kumar et al., 17). There is such a thing known as opportunistic disinflation, and in the late 1900s there was a period where inflation was lowered from 11% to 3.5%, “the central bank would sustain boom periods with low rates but quickly rise rates after recessions to preserve a lower rate of inflation” (Haltom). The long term effect of this was reducing the great effect that such a high rate of inflation would have on the economy. Recent events have also likely increase the neutral rate of inflation which consist of, but are not limited to, swelling government deficits, investment in clean energy, and productivity boosting investment opportunities such as AI (Timiraos). There is a happy medium where the economy can stabilize at in a perfect world, however, because of the different aspects that fuel what inflation sits at, it can be said that inflation may just have to remain at a slightly higher rate than what we were used to.

https://www.dol.gov/general/topic/statistics/inflation (inflation definition)

Notes: raised neutral inflation rate, what led to deflation prior (China/outsourcing/tech/mobility), can any of that be reproduced to lower inflation? What can lead to inflation (green energy push, higher min wage push higher government spending, higher global debt levels)

https://www.wsj.com/economy/central-banking/why-the-era-of-historically-low-interest-rates-could-be-over-49bcdc59

– Neutral rate of interest: rate at which demand and supply of savings is in equilibrium → stable economic growth and inflation
– “Swelling government deficits and investment in clean energy could increase demand for
savings” → makes neutral rate higher, higher public debt
– Productivity boosting investment opportunities (AI) could increase neutral rate
– Business investment depreciates faster

https://www.cfr.org/blog/history-and-future-federal-reserves-2-percent-target-rate-inflation-0

– 2% target rate was adopted in 2012 following New Zealands trend (maybe?)
– Why is it 2%?
– Hard to measure inflation directly (upward bias in inflation measures)
– Leaves room to cut interest rates to stimulate economy
– Buffer against deflation
– Question: is it worth raising interest rates even further risking recession and jobs, just to bring inflation down to a percent that is random?
– Flexible average 2% in the long run target rate

https://www.wsj.com/articles/the-fed-should-carefully-aim-for-a-higher-inflation-target-reserve-powell-greenspan-5fef5051 (Furman)

– Higher inflation can help the fed stimulate investment (any given nominal borrowing cost becomes less onerous when businesses can count on future price               increases to meet it)
– 1990s policy makers decided on 2% and formalized in 2012
– Transitioning to a slightly higher inflation rate- Intent is not to raise inflation just to avoid pain of getting inflation down
– Need to stick with target inflation rate so fed’s credibility is not questioned

https://www.imf.org/external/pubs/ft/def/2003/eng/043003.pdf (history of deflation)

– Collapse in aggregate demand and credit channels & policy mistakes drove deflation in the late 1920s and early 1930s

https://www.richmondfed.org/publications/research/econ_focus/2014/q3/jargon_alert (Haltom) (Disinflation)

– Most favorable disinflation period: 1980s went from 11% to 3.5%
– “Opportunistic disinflation”: central bank would sustain boom periods with low rates but quickly rise rates after recessions to preserve lower rate of inflation →         gradual disinflation
– Short term cost of unemployment
– Long term gain in reducing distortions of inflation
– Deflation is not good → be vigilant in disinflation episodes
– 2008 great recession
– Interest rates were near zero to stimulate growth and mitigate risk of deflation