“If the Fed wants more inflation, it should say so” is the titleof an article published in The Economist authored by RyanAvent that discusses the actions of the Fed’s Open Market Committeein setting benchmark interest rates. The article takes aconfrontational approach as indicated by the title. The author isincensed by the fact that the Federal Open Market Committee headed byJanet Yellen was coy to acknowledge its desire for higher inflationrates. Making such intentions known is beneficial to the economy. Theauthor’s argument is borrowed from the inverse relationship betweeninterest rates and inflation. Given that interest rates have remainednear zero in the last several years, individuals are likely to haveborrowed more, spent more, and grown the economy. Ideally, access toloans increases the amount of money in circulation without activelyincreasing quantity/quality of goods and services leading toinflation indicated by a general increase in prices. Thus, by the Fedmaintaining low interest rates, it is implying that it is receptiveto inflation rates above the target of 2% but has not made thatclear.
Therefore, to arrest inflation the Fed should increase interestrates. However, the US is not a closed economy. An increase inbenchmark interest rates would attract capital from all over theworld where most markets have maintained near-zero rates. Investorswould flock to the US in anticipation of better returns on saferassets. The demand for the dollar would go up placing a drag ongrowth. As a result, the price of riskier assets would fall and thebenchmark interest rates would have to be lowered again to drivegrowth. Thus, the actions of the Fed are tied up with the fate ofother markets. In the current case, attempts to increase interestrates have been hindered by fears of slowing the economy. Again,maintaining interest rates at near-zero is dangerous as it denies theFed enough room for maneuver without resulting into less-proven toolssuch as negative rates. Thus, the author observes that the Fed is ina very precarious situation.
However, the author has a potential solution to the problem. Heargues that it is possible for the Fed to increase nominal interestrates without necessarily increasing inflation-adjusted or realinterest rates. Such a move is possible if expectations of futureinflation rate keep rising to a level not too low to be ignored i.e.consumers only worry about significantly high inflation rates.Assuming that there is public expectation of moderate medium-terminflation rate growth (2% -4%), then the nominal interest rates wouldregister relative increment without necessarily increasing realinterest rates. Thus, the author believes that it is wrong for theFed to be shy about its intentions of pursuing inflation rates higherthan the set target of 2%. Making such information public wouldencourage public expectations of moderate medium-term inflation rategrowth. Unfortunately, the Fed has established a culture of strictadherence to low inflation rates that it would require a considerablylong period of time for the public to change its beliefs about theFed. Thus, to address the current cycle driven by fear, the Fedshould strive to change public expectations in terms of inflationmovement.
Thus, from the above discussion, it is clear that the Fed is not outof options in setting the economy on a recovery path unhindered byfear of stagnation. Being open about the Fed’s policy and approachto the current situation would ideally solve the current dilemma ofincreasing interest rates without encountering the fears of thecontractionary nature of higher interest rates. Thus, the articleadequately covers the economic concepts of interest rates andinflation.
Avent, R. (24thMar 2016). If the Fed wants more inflation, it should say so. TheEconomist.