Why does the Federal Reserve want Inflation?

Investing, as we all know, involves risk. In fact, there are several – to name just a few, there is market risk, interest rate risk, currency risk, default risk, political risk, economic risk, and even natural disaster risk.

Now if you want to avoid most of these risks, you can always keep all of your cash in a bank account. But did you know that not investing also carries risk? First and foremost is the risk of loss of purchasing power, also known as “inflation” risk.

Inflation, defined as a general rise in the level of prices, erodes your purchasing power over time. Because of inflation, one dollar today is worth more than a dollar will be in the future. Even at a relatively benign inflation rate of just 2% per year, the purchasing power of one dollar today becomes 82 cents in 10 years, 67 cents in 20 years and only 55 cents in 30 years!

One of the main goals of investing, therefore, is to maintain (and grow) your purchasing power, which requires earning a return above the expected rate of inflation.

Now that you are familiar with the risk of inflation, have you ever wondered why the Federal Reserve of the United States specifically targets a level of 2% inflation per year? Why not simply target 0% and keep the price level more or less stable? Wouldn’t this help to maintain everyone’s purchasing power?

The short answer to that question is that the Federal Reserve (the “FED”) desperately wants to avoid inflation’s evil opposite twin, deflation, which is a sustained decline in the general price level. By targeting a positive rate of inflation, it acts as a “buffer”, keeping the US economy from falling into outright deflation. But this naturally leads us to the next question – what’s wrong with falling prices? And why does the FED want to avoid that?

There are at least three potentially negative outcomes that deflation may cause. The first relates to a shift in “consumer expectations”, in that if consumers come to expect prices to decline in the future, they may delay purchases for as long as possible. This happened during the Great Depression, and is what’s known as the “death spiral” scenario, wherein sales volumes fall, harming corporate profits, which eventually reduces employment and slows economic growth even further, causing an even larger decline in prices, etc.

The second negative outcome of deflation is an increase in the ‘real’ value of existing debt in the economy. Since interest rates and repayments are largely fixed on most consumer loans, inflation can be good for debtors – the ‘real’ (inflation-adjusted) value of their loans declines over time, easing the burden of the debt and aiding their eventual pay-off. Deflation has the opposite effect, making the ‘real’ burden of their debt grow larger over time.

Finally, a lesser-known benefit of positive inflation is the improvement of employer flexibility on labor costs. Imagine an economic slowdown that reduces corporate incomes. With labor costs largely fixed, a company may struggle to remain profitable. But if inflation is positive, rather than being forced to cut wages or fire a portion of its employees to save costs, a company can temporarily freeze wages and the ‘real’ cost of labor will fall over time until the economy picks up again. In a deflationary environment, companies have no such flexibility, and the negative effects on national employment from recessions would likely be more severe.

There is a trade-off to any given rate of inflation or deflation to be sure, and there are winners and losers under different scenarios. The FED has determined that an inflation rate of about 2% is somewhere near the ‘goldilocks’ level – not too hot or cold, and one that largely avoids the negative outcomes of both high inflation and outright deflation as well. Your opinion on the right amount of inflation might differ, and may depend on whether you are a borrower or a saver.