The Fed Wants Higher Inflation. Should You?

September 17, 2020, 7:00 AM EDT

A hot air balloon in the pattern of the U.S. flag being inflated at the Steamboat Springs Hot Air Balloon Festival in 2019

The Federal Reserve desperately wants higher inflation. But does the rest of America?

For decades, the central bank fought back against any hint of accelerating inflation after the uncomfortable experience of double-digit annual price growth in the late 1970s and early 1980s. More recently, the Fed has faced the opposite problem — it can’t seem to get inflation to its 2% target. For that reason, Chair Jerome Powell announced recently a shift in how the central bank will conduct monetary policy, which would allow inflation to exceed its 2% target for a while to make up for the period it fell short of that level. Fed officials this week explicitly pledged to keep interest rates near zero until they see proof that inflation will exceed its target.

Inflation is a notoriously complex economic concept, in no small part because the U.S. government has more than one measurement, and the weightings assigned to the basket of goods and services can only hope to approximate the average American household. But the push for persistently higher prices might raise some unsettling questions. Am I going to end up with a bunch of meaningless paper money? (No.) If not that, will the value of my cash at least fall? (In the U.S., sure. In other countries, perhaps not.) Will the Fed be successful? (Probably not on its own.) Are there things I should be doing in case inflation takes off? (Yes, though chances are you were thinking about them already.)

We’ll explore those questions further, but before that, it’s worth stepping back to see which parts of American life have experienced rampant price growth over the past decade and which have kept inflation stubbornly below the Fed’s 2% objective.

Understanding Inflation’s Inner Workings

About those two different measurements of inflation. The Fed, for its part, prefers to follow the personal consumption expenditures index (PCE) from the Bureau of Economic Analysis rather than the more commonly cited consumer price index (CPI) from the Labor Department. Core PCE, which excludes volatile food and energy prices, exceeded the central bank’s 2% target only twice during the longest economic expansion in U.S. history: From December 2011 to April 2012, and then intermittently in the final 10 months of 2018.

Over the years, services have made up an ever-larger share of overall PCE data, reflecting the shift in the U.S. economy.

Remember, the government’s inflation data is based on a basket of goods and services, which doesn’t stay static over time. Certain essential items no longer take up quite as much space in Americans’ budgets, while others are becoming more prominent.

Inflation plays a large role in this shift.

It’s overwhelmingly clear that inflation is alive and well in the service economy but languishing when it comes to the price of various goods.

The difference, of course, is that services are primarily done in the U.S. by American workers. Globalization has moved supply chains for goods into countries with cheaper labor. That’s been a boon to the end-consumer — hence the lower weighting for furniture and clothing in U.S. expenditures these days — but at the expense of manufacturing jobs as well as inflation.

Next is a deeper dive into the areas of the economy experiencing inflation versus those facing deflationary pressure.

This scatter plot reflects every category listed in the U.S. PCE data. A 2% annual inflation rate over 20 years would bring about a roughly 50% overall increase in prices. Indeed, many of the data points are bunched right around that level, with expenditures as diverse as gambling, sugars and sweets, and motor vehicle parts and accessories.

The outliers are perhaps the most interesting, however.

For instance, the gray dots represent measures of highly volatile energy prices, including the price of oil, gasoline and other motor fuels and lubricants. The cost of a barrel of oil is actually little changed from this time 20 years ago — $39 now compared with $36 in September 2000 — but that masks the large price swings in that period. The price hit a high of about $145 in 2008 and famously collapsed toward zero earlier this year. This volatility is why the Fed prefers to look at core measures of inflation, which strip out commodity prices.

While this kind of price inflation is most apparent at the college level, with young Americans saddled with some $1.5 trillion in student debt to cover the high cost of admission, the cost to attend elementary and secondary schools has also increased by more than 150% since 2000.

And then there’s the incredible deflation in electronics as a whole.

Many of these categories represent electronics that have either become ubiquitous or outdated in everyday American life, depending on whom you ask. The advent of smartphones that can effectively do video, audio and photography on their own (plus a lot more) has suppressed the cost of these once-pricy gadgets.

Meanwhile, the costs of housing, child care, elder care and college are on the rise, and even the coronavirus pandemic seems unlikely to permanently alter these long-term trends. These services will continue to put pressure on household budgets across America.

If the Fed successfully encourages price growth in other areas of the U.S. economy, what might that mean for the dollar’s place in the world?

Source: International Monetary Fund
Note: Data as of Q1.

Investors often use the acronym TINA (There Is No Alternative) when it comes to buying shares of large American companies. But in the foreign-exchange market, there truly seems to be no option other than the U.S. dollar. It commands the majority share of official foreign-exchange reserves, at about $6.8 trillion, according to the International Monetary Fund. That’s more than triple its next-closest competitor, the euro, which only came into being in the late 1990s. And while China may be the second-largest world economy, the renminbi is still considered a second-tier currency at best.

Simply put, the dollar remains the most-sought-after currency in the world. That will remain the case even if U.S. inflation picks up beyond the Fed’s 2% target. So, no, you are not going to end up with useless paper money. Don’t embarrass yourself with comparisons to hyperinflation in places like Venezuela and Weimar Germany.

Obviously, if prices on goods and services increase by 2% or more each year, every dollar saved will buy less domestically as time goes by. Inflation is often called a “tax on savers” for this very reason. So, yes, the value of cash will fall.

It’s not such a clear-cut proposition when considering the global economy. The dollar’s value, as measured against a basket of other currencies in the Bloomberg Dollar Spot Index, has weakened drastically during the Covid-19 pandemic. That’s due in no small part to persistent outbreaks across the country while other nations have slowed their spread. If U.S. inflation picks up for “good” reasons — namely, the prospect for stronger economic growth — the dollar should strengthen relative to other currencies. That would make it cheaper to vacation in Europe or buy goods from Japan. In that sense, at least, every dollar will go further than before, even with inflation climbing.

Remember, the Fed Can’t Talk Inflation Into Existence

Inflation isn’t going to suddenly sprout up in America just because Powell and his colleagues at the Fed say so. They are limited to moving short-term interest rates and buying financial assets, which is a roundabout way of influencing the real economy. It needs to happen organically, and it starts with people finding good jobs. Even though the central bank is questioning its own assumptions about the interplay between employment and inflation, no one expects prices to soar when so many workers are furloughed or permanently out of work. There’s simply not enough demand.

One wild card is if Congress passes an aid bill like the one it did earlier in the pandemic. Those extra $1,200 checks and increased jobless benefits almost single-handedly propped up consumers and prevented a more sustained downturn. But Republicans appear less inclined to offer such a sizable package with the economy seemingly on the mend. That will most likely halt any sort of across-the-board overheating.

Someday, inflation may exceed 2%. But it won’t be today, nor tomorrow, and, judging by the Fed’s own outlook, probably not next year. Bracing for accelerating price growth involves what most Americans probably strive for anyway: owning real estate and skewing investments toward equities instead of fixed-income assets (except perhaps for Treasury Inflation Protected Securities) while spending prudently on services and experiences that are likely to only get more costly later.

In truth, the Fed should consider its framework review a success if it has put inflation on the radar of most Americans, who didn’t seem to have a clue about what would happen to prices during the worst of the coronavirus pandemic. For Powell, it’s all an expectations game. All he asks is for you to remember that prices can — and, in the eyes of central bankers, should — go up.

The Fed Wants Higher Inflation. Should You?

Understanding Inflation’s Inner Workings

America’s Economy Is Skewed Toward Services

A Look Inside the Basket

The Great Inflation Divide

21st Century Inflation

Technology Is Drastically Cutting Prices of Big-Ticket Electronics

Even If Inflation Picks Up, the U.S. Dollar Is Still King

But the Dollar Isn’t Invincible

Remember, the Fed Can’t Talk Inflation Into Existence