The U.S. Federal Reserve System grapples with the inflation dilemma

Yiwei Wang, Contributing Writer

The U.S. Federal Reserve System is frustrated with the current inflation rate, which, on average, has been hitting below the target percentage of 2 percent.

The Federal Reserve defines inflation as a “general increase in the overall price level of the goods and services in the economy.” With an average U.S. inflation rate of 1.5 percent in 2013, 1.6 percent in 2014, 0.1 percent in 2015, 1.3 percent in 2016, and 1.4 percent in 2017, the Federal Reserve scrambles to seek out appropriate measures that will seal the inflation rate at the ideal 2 percent.

Before we explore the options available to the Federal Reserve, we need to first understand what the Federal Reserve does and why low inflation is detrimental for a stable economy. We have learned that high inflation is bad, but why should we be so concerned with a low one?

The Federal Reserve was created by Congress “to provide the nation with a safer, more flexible, and more stable monetary and financial system.” In essence, the Federal Reserve is responsible for the general macroeconomic policies that govern the U.S. economic environment.

It is true that one of the main directives of the U.S. central banking institution is to “keep a lid on inflation.” Hyperinflation, which occurred in the 1970s, can cause severe damage to the economy. In this case, the easy-money policy put out by the central bank caused high inflation after trying to lower the unemployment rate; however, having a very low inflation rate (less than 2 percent), can be just as detrimental to the economy.

With low inflation, prices increase slowly and consumers are more likely to halt their expenditures. It raises the question, “Why wouldn’t one buy the same number of goods or services in the future with same or lower prices?” Therefore, fewer commercial activities in the economy will slow down the economy growth.

Low inflation tends to stagnate income growth. In simpler terms, an employee is not going to receive a raise when the revenue of the company does not grow significantly from the previous one. As a direct consequence, individuals and households who live on roughly the same level of income as before will feel the full brunt of the stagnating economy and, as a result, will have a challenging time paying back the interest-bearing debt.

The most dangerous scenario of low inflation is the direct correlation it has with deflation (a contraction of the money supply circulated within an economy), which devalues the price of the dollar, the stock value, and the value of other debt-based financing businesses such as banks and the government.

In an effort to raise inflation, many see two possible approaches to improve the current situation.

The first option would be to push down the current unemployment rate (4.4 percent) below its natural rate until inflation returns to the ideal 2 percent. By manually adjusting the unemployment rate, the Federal Reserve could face the possibility of overshooting. If that occurs, the Reserve will need to slowly deflate the economy so it will stay at the 2 percent. The process of cutting back inflation by the Federal Reserve would likely result in a recession.

The second option would be to forget the target 2 percent inflation rate. This will not only damage the Federal Reserve’s credibility and reliability in the market, but it will also force the interest rate to lower.

“It is premature to reach the judgement that [the U.S. is] not on the path to 2 percent inflation over the next couple of years,” Chair of the Board of Governors of the Federal Reserve Janet Yellen said. Any major decisions are expected to be deferred until later in the year. It is important to note that there will be risks and losses involved if the Federal Reserve implements policies corresponding to either of these options.

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