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The US Federal Reserve and Inflation

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One of the numerous tasks of the US Federal Reserve – America’s central bank – is the maintenance of stable prices. The last few chairmen (and one woman) of the Fed have had a fairly easy job when it comes to keeping prices (inflation versus deflation) on an even keel. You have to go back almost 30 years, to 1991, to find the US inflation rate nudging above an annual 4%. Since that year it has occasionally crept above 3% but has generally been much lower.

Since the mid-1990s the Fed has ‘targeted’, i.e. aims to achieve, an annual rate of 2%, but this year US inflation is likely to be around 1.75%. Any change in this policy is rather unusual. It might have reverberations around the globe; for, as US interest rates go, others tend to follow.

Maintaining stable prices in an economy the size of the US – the world’s biggest since 1871; this year its gross domestic product (GDP) is likely to be more than $21 trillion –inevitably is a herculean task. No-one really manages this outsize octopus: it manages itself. With regards to stable prices, all the Fed can hope to do is to stop it from keeling over into runaway inflation on the one hand, or collapse into deflation on the other. The Fed, of necessity, needs a sensitive touch on the tiller.

For most of us that light touch manifests itself through Fed’s changes to US interest rate policy – pushing rates higher when the economy seems likely to overheat, or lowering them when it seems in danger of stalling. That’s been its conventional wisdom for what seems like forever, perhaps since 1913, when President Woodrow Wilson signed the law that established the Federal Reserve System. So the news that the Fed is considering relaxing its 2% target for inflation might turn out to deserve much more attention than it has so far received. As often the case, central bankers prefer euphemisms to disguise hard truth; so the Fed say it is thinking about what it calls a “make-up strategy” rather than simply saying ‘we’re going to abandon the 2% target’, and it is easing market acceptance of this by careful news management.

This abandonment of the 2% target has been floating around the think-tanks of Washington D.C. for some time. In June 2018 the Brookings Institution published a paper on this topic, which ended by rhetorically asking “wouldn’t a little higher inflation be nice for everyone?” It all depends on what is meant by a “little”. Not the kind of inflation that happened in Hungary in 1946, where prices doubled every 15 hours; in August 1946 the total value of all Hungarian banknotes in circulation was worth one-tenth of a US penny.

President Gerald Ford gave away lapel badges in the mid-1970s with the slogan ‘WIN’ – which stood for “whip inflation now” – when inflation was running at around 6.5%. But today, with unemployment the lowest it has been for decades, the printing of money, and extremely low interest rates, inflation seems like a thing of the past, like a dead dinosaur. The big worry right now for the Fed (and the European Central Bank and most other central banks too) is deflation. Deflation shrinks consumer demand, which can lead to lower prices, companies going out of business, trading collapses…pretty soon a deflationary economy starts to resemble Japan’s “lost decade”. In Japan, more than 20 years of zero interest rates has still failed to push annual inflation up to 2%: all kinds of odd suggestions are now being made, such as the abolition of cash.

One can sympathise today with the US Federal Reserve; indeed with all central bankers. They have tried just about every trick in their books to steer their national economies towards growth rates above a couple of per cent – low to negative interest rates, money-printing, and even using the central bank to buy shares in publicly traded companies, in the case of Japan. All this has been to no avail.

As central bankers fret, however, the risks of them falling prey to extreme temptations become ever greater. Abolishing cash sounds crazy right now, but who knows? The idea of developing national digital currencies and giving this ‘stable money’ to households, on condition that it is spent, not saved, would certainly spur inflation – but the law of unintended consequences might well come into play.

Perhaps all that can be safely said is that with each passing day the uncertainties are increasing; who would have imagined that the Fed would drop its once-iron rule of targeting 2% inflation. In this scenario it seems logical that people are increasingly thinking of holding more gold, valuing its certainty in the swirl of growing certainty.

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