Home / Opinion / Views /  Mint Explainer: The trouble with America's 2% inflation target

The US Federal Reserve is meeting at a time domestic inflation has ebbed, but the war against rising prices is still on. The US economy expanded at a faster pace than expected in the December quarter and the job market remains strong. Now, the Fed will be wary of going overboard with interest rate hikes, but its relentless pursuit of a 2% inflation rate may just tip the US into a recession. If the Fed is more flexible with its inflation target in the near to medium term, it may reduce the economic pain for the US, and the world. The Fed hiked interest rate seven times in 2022 alone, a whopping 425 basis points, raising the target federal funds rate range to 4.25%-4.5%.

Inflation eases, but remains a threat

The Federal Reserve Open Market Committee (FOMC) is holding its first 2023 meeting on 31 January and 1 February. Inflation is easing, wage growth has cooled and consumer spending has tapered off, but Federal Reserve chair Jerome Powell can't quite relax yet. In fact, there are conflicting macroeconomic signals for the Fed.

The core Personal Consumption Expenditures (PCE) index – without volatile food and energy categories – grew 4.4% in December, down from the annual rate of 4.7% in November. It’s the gauge the US Fed monitors closely. Meanwhile, the economy grew faster than expected in the December quarter and the job market continues to be quite strong - in fact, unemployment rate actually has slipped to 3.5% from 3.6% in December, the lowest in half a century.

The worry for the Fed is that as long as the job market remains strong, the threat of elevated inflation remains. It may convince the FOMC to persist with measured rate hikes in the near term. But can the war against inflation be won without the US sliding into a mild – if not a deep – recession? That will be a big challenge for Powell.

Why recession remains a threat

There’s a high probability of the US slipping into a recession as the Fed relentlessly pursues its goal of 2% inflation in the near term. The Fed has already raised rates by a whopping 425 basis points in 2022. The full force of these hikes will be felt over the next few months, since the impact of monetary policy shows up with a lag. And more rate hikes, though likely to be smaller, may be on their way.

It’s a deep-seated problem in the US at the moment. While unemployment levels are at historical lows, CPI inflation has outpaced wage growth since April 2021, despite structural demand-supply imbalances in the labour market.

The Fed will be hoping that the job market will cool off quickly without a contraction in economic activity, minimizing the economic pain for the US, and the world. But a recession is a real possibility if the Fed aggressively pursues an inflation target of 2% in the near term.

The Fed will be wary of going overboard with interest rate hikes that could tip the US into a deep recession. Letting the economy slide slowly towards the 2% target over the long term may reduce the economic pain for the US, and the world. It may mean a milder recession, if at all. Remember, the 2% target is not an end in itself. In fact, the Federal Reserve Bank of St. Louis has observed on its website that “the inflation target (of 2%) is meant to be reached over a longer period of time".

Learning from the past

Surely, the Fed must take some censure for how deeply entrenched inflation expectations are in the US economy. The pandemic prompted the Fed to launch an unprecedented blitz to revive the economy. Not only did it slash interest rates, it also launched a massive quantitative easing programme, buying US government and mortgage-based securities. The Fed may have possibly gone overboard, and the liquidity gush triggered the surge in inflation, overheating the US economy.

The Fed is now shrinking its balance sheet, letting its maturing securities “roll off" without replacing them but as Powell observed in June last year: “I would just stress how uncertain the effect is of shrinking the balance sheet".

What it means for the world

If the US economy averts a hard landing, it will support the global economy as well, particularly the developing economies. Also, a strengthening dollar has been exporting inflation to other countries, including India. The rupee had depreciated more than 10% in 2022 alone. If the Fed goes slow on hikes, it will allow other central banks, including the Reserve Bank, to taper off interest rate hikes as well.

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