Why Inflation Matters in Setting Monetary Policy

In January 2014, the Federal Reserve began reducing the pace of bond purchases that started in September 2012, a process that has been dubbed “tapering” in the news. Markets are currently expecting this reduction to continue until the eventual end of the bond-purchasing program and even engage in further tightening of monetary policy if economic indicators continue improving. However, the persistence of low inflation could signal otherwise.

The Federal Open Market Committee (FOMC) currently interprets its price stability mandate as 2 percent annual inflation, as measured by the personal consumption expenditures price index. The chart below displays annual inflation at a monthly frequency since January 2000. If we remove food and energy (the most volatile components in the price index), we get a smoother measure of inflation, often called core inflation. Focusing on core inflation gives us a better idea of the effects of monetary policy in the medium and long runs.

The chart shows core inflation averaging about 2 percent annually until the end of 2008, right in the middle of the last recession. Since then, core inflation has been persistently below the 2 percent annual rate. More recently, since the beginning of 2012, core inflation has been steadily decreasing toward a 1 percent annual rate. (Note that the overall inflation rate, including all components, exhibits a similar trend.) This decline can be explained by a marked deceleration in the inflation rate of nondurable goods, which itself is arguably unrelated to recent developments in monetary policy.¹

The successful implementation of an explicit inflation target relies on the credibility of a central bank’s ability to meet the announced target, at least on average over the medium run. In this sense, it is as problematic to let inflation run up persistently above the stated target as it is to let it run down. Thus, policymakers not only need to manage the supply of money, but also need to keep an eye on the demand for money. In particular, an understanding of underlying trends in the price level is necessary to effectively forecast inflation over the medium run, and thus, forecast monetary policy.

As economic indicators such as the unemployment rate move closer to their precrisis levels, markets likely expect the FOMC to further tighten its monetary policy. However, if the underlying, demand-driven downward trend in inflation persists, the FOMC may instead decide to continue implementing a loose monetary policy to meet its inflation target and maintain credibility.

¹ See the Economic Synopses “U.S. Inflation and Its Components”

• On the Economy: Lowflation in Advanced Economies
• On the Economy: Inflation and the Role of Fed Credibility
• Economic Synopses: U.S. Inflation and Its Components