Optimism on Inflation: When Is Enough Just Enough?

Moderate inflation remains the central economic barometer to keep growth and interest rates on the optimistic path already anticipated by financial markets. How do we maintain moderate inflation?

A 30-Year History in Favor of Moderate Inflation

A modest amount of inflation is considered a means to grease the wheels of enterprise. Yet, too much inflation is a threat to monetary policy goals and the bond market. As illustrated in the top graph, the U.S. economy has maintained an average rate of inflation a little below 2 percent despite the volatility of the economy and financial markets over several business cycles.

Domestic policy changes, combined with the global movements of goods/services and financial capital, have supported this pattern of persistent, moderate inflation. The flow of goods and services has lowered the inflation rate of final products as well as the major inputs that go into the final products produced in the U.S. Meanwhile, capital flows into the U.S. have supported business investment and thereby increased the aggregate supply of final products as well as the fixed structures and business equipment that increase the domestic production capabilities of the economy. Recent inflation trends highlight the difference between goods and services within consumer prices. Core goods deflation has averaged 0.5 percent over the past two years, while core services inflation has averaged 2.8 percent over the same period. Movement of tradeable goods has certainly moderated the pace of inflation for goods. In a sense, the movement of tradeable goods acts as an increase in the aggregate supply of goods and thereby helps moderate inflation.

Aggregate Supply and the Fed: The Case for Optimism

Supply-side initiatives remain the key to maintain low inflation in the real economy, while the commitment by the Fed to its medium-term inflation target remains the central policy pillar.

On the supply-side, incentives need be focused on improving the availability and quality of the labor force—neither an easy nor a quick task. Higher wages, without productivity gains, simply raise unit labor costs without benefiting the medium-term outlook for the economy. The global competitive environment demands a more educated workforce than in the past as American production of both goods and services is compelled to move up the value chain. For non-labor costs, a sense of balance between the costs and benefits in our regulations would provide incentives for development. More investment would help overcome the stagnant technology in many sectors as well as the gap between the least and most productive firms

Long-Run Inflation Control Depends on the Fed

The conduct of monetary policy since the 1970s has focused on controlling inflation in the medium-term. This focus remains the central core to any strategy of stronger, more sustained, growth over time. Moderating interest rates in the face of rising inflation is not a signal for sustained growth.

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