Skip to content

Why Inflation Matters in Setting Monetary Policy

Monday, May 5, 2014

By Fernando Martin, Senior Economist

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.

Notes and References

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

Additional Resources

Posted In Inflation  |  Tagged core inflationfernando martinfomcinflationmonetary policypersonal consumption expenditures price indexprice stabilitytapering
Commenting Policy: We encourage comments and discussions on our posts, even those that disagree with conclusions, if they are done in a respectful and courteous manner. All comments posted to our blog go through a moderator, so they won't appear immediately after being submitted. We reserve the right to remove or not publish inappropriate comments. This includes, but is not limited to, comments that are:
  • Vulgar, obscene, profane or otherwise disrespectful or discourteous
  • For commercial use, including spam
  • Threatening, harassing or constituting personal attacks
  • Violating copyright or otherwise infringing on third-party rights
  • Off-topic or significantly political
The St. Louis Fed will only respond to comments if we are clarifying a point. Comments are limited to 1,500 characters, so please edit your thinking before posting. While you will retain all of your ownership rights in any comment you submit, posting comments means you grant the St. Louis Fed the royalty-free right, in perpetuity, to use, reproduce, distribute, alter and/or display them, and the St. Louis Fed will be free to use any ideas, concepts, artwork, inventions, developments, suggestions or techniques embodied in your comments for any purpose whatsoever, with or without attribution, and without compensation to you. You will also waive all moral rights you may have in any comment you submit.
comments powered by Disqus

The St. Louis Fed uses Disqus software for the comment functionality on this blog. You can read the Disqus privacy policy. Disqus uses cookies and third party cookies. To learn more about these cookies and how to disable them, please see this article.