Economic Perspective: Why the Fed Wants Inflation

MARY WALDEN:

“Today’s program asks why the fed wants inflation. Mike, although the inflation rate will likely increase modestly this year, for many years the Federal Reserve has worried that the inflation rate has been too low. Why would the Federal Reserve want prices to rise faster?”

MIKE WALDEN:

“Well that’s a very common question. I get that question all the time when I do talks with public audiences about the economy. Most people think, ‘Hey, zero inflation, that’s what the Fed should try to get. Not something higher.’”

“Well I think there are a couple of logical reasons why the Fed might want a targeted inflation rate that’s above zero. One is that there is a lot of evidence, now many people won’t agree with this, but there’s actually a lot of evidence that the measure of inflation rate actually overstates true inflation.”

“There was a study, very famous study, done a couple of years ago that said that probably measured inflation overstates real inflation by about 1.5 percentage points. So that would be one reason why you would want an inflation rate that’s actually higher than the measured rate. Say if you’re after zero, well at 1.5 measured that means you are at zero.”

“The second big reason is that the Federal Reserve, as well as most economists, think that people suffer from money illusion. Let’s say that you get a two percent raise. If however the inflation rate is two percent you’re really not ahead. So that’s just as good as if you got no raise with zero inflation, but the notion is people don’t think like that. They look at the actual raise, and they don’t like it if they get zero percent in their raise. So they’re actually feeling better if they get say a two percent raise even if the inflation rate is two percent. So that’s what we mean by money illusion.”

“So the Fed has used that as a second reason why they might want to target inflation of being higher than zero percent.”