Will the Fed Hit Its 2% Inflation Mark?

Chief Economist Eugenio Alemán and Economist Giampiero Fuentes note that while it is taking longer to bring inflation down, the Fed will continue to conduct monetary policy to reach its target rate.

Key Takeaways:

  • The Federal Reserve (Fed) estimates that 2% for the Personal Consumption Expenditure (PCE) price index over the long run is the most favorable rate of inflation to support one of the institution’s dual mandates: price stability. The Fed’s second mandate is to keep the rate of unemployment as low as possible.

  • Over time, there has been an inverse relationship between the rate of inflation and employment. If the rate of unemployment is too low, the rate of inflation would tend to increase, and vice versa. This is known as the Phillips Curve. But this relationship has broken down and a question for the Fed is whether the Phil­lips Curve will once again apply.

  • Inflation occurs when there is a generalized increase in the level of prices in an economy. There are two ways in which inflation occurs, ‘cost-push inflation,’ which occurs when there is an increase in the cost of production in an economy, and ‘demand-pull infla­tion,’ which is when the demand for goods increases.

  • Inflation has increased to the highest level in 40 years mostly due to consequences of the pandemic, including product shortages, supply chain disrup­tions, highly expansive fiscal policy, and strong consumer demand. Once these things normalize, inflation should return to the Fed’s long-term target.

  • The Fed is going to conduct monetary policy to reach its target rate of inflation. It is not going to change the target.