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Why The Fed Keeps A Close Eye On Consumer Prices

Oct 31, 2016
Originally published on October 31, 2016 9:22 am
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Here in the U.S., inflation doesn't get much attention. That's partly because of numbers like this - prices for U.S. consumers rose 1.7 percent over the last year, according to a report released this morning by the federal government. But as Jacob Goldstein of our Planet Money podcast reports, inflation is hugely important to some of the most powerful people in the economy.

JACOB GOLDSTEIN, BYLINE: The figure is called personal consumption expenditures, or PCE, and it's the key inflation figure for the leaders of the Federal Reserve. This is a big deal because the Fed has a huge influence on the economy. The Fed has the power to raise and lower interest rates. And it's supposed to use this power to steer the economy for both full employment and low inflation. When unemployment is high, the Fed lowers interest rates. When inflation is rising, the Fed raises rates. And a few years back, the Fed publicly announced that it would target 2 percent a year inflation as measured by PCE. Why 2 percent? To find the answer, I called up Alan Blinder. He's an economist at Princeton.

Why 2 percent?

ALAN BLINDER: That's a really good question so...

GOLDSTEIN: (Laughter).

BLINDER: ...Because it's not so obvious that two is the right number.

GOLDSTEIN: Blinder was vice chair of the Fed back in the mid-'90s. He told me back then, even people within the Fed couldn't agree on what inflation rate the Fed should target.

BLINDER: Some people thought we should be shooting for zero. Some people thought we should be shooting for 2 percent. Some people were content with the 3 percent, which is about where we were.

GOLDSTEIN: In the years after Blinder left the Fed, there was this convergence on that 2 percent number. Here's why - you want inflation to be low. High inflation creates all kinds of problems. But you also do not want inflation to go below zero. You do not want deflation. That means you have falling prices and falling wages. And that's bad for people who have debts, tends to lead to more bankruptcies. It's bad for the economy overall. And, Blinder says, the Fed knows that whatever inflation rate it targets, they're not going to hit it right exactly on the nose.

BLINDER: Whatever long-run target the central bank sets, what you're going to see in history is random fluctuations above and below. So if you're quite worried about going below zero that argues to give yourself a buffer.

GOLDSTEIN: So you start at zero, give yourself a little buffer so you don't slip into deflation, and you get to 2 percent. Blinder says it took the Fed a long time to agree on this number internally. And then after that, they had to decide, OK, now we're ready to talk publicly about this. And so finally on January 25, 2012, Ben Bernanke, who was the chairman of the Fed at the time, had this press conference where he told the world.


BEN BERNANKE: The committee judges that inflation at the rate of 2 percent as measured by the annual change in the price index for personal consumption expenditures is most consistent over the longer run with our statutory mandate.

GOLDSTEIN: Boom - 2 percent. So here we are now, almost five years later. And it's a good thing that the Fed gave itself that buffer. A few months after Bernanke made this announcement, inflation fell below 2 percent. And since then it's been below 2 percent every single month. That is a big part of the reason that the Fed has held interest rates so low for so long. Jacob Goldstein, NPR News. Transcript provided by NPR, Copyright NPR.