Budgeting and Forecasting

Learning to Love Inflation

From 1980 to 2000, average annual inflation was 4.24 percent. Those of us who came up in that era were told to carefully account for it when forecasting budgets and investing public money. But since 2001, inflation has hovered at just over two percent, and since 2015 it’s been an ultra-low 1.54 percent.

Basic macroeconomics tells us we can’t simultaneously have the low interest rates, low unemployment, and low inflation that we’ve enjoyed for a decade. The traditional story is that low unemployment causes workers to demand higher wages, those higher wages drive up prices and inflation, and the Fed then stops that inflation by cooling off the economy with higher interest rates. It was only a matter of time until we stopped defying the laws of macroeconomic physics.

Then came COVID-19. Now we’re about to enter a brave new world of post-COVID-19 Fed policy. On August 27, 2020, Federal Reserve Chair Jerome Powell made an historic announcement. He said the Fed would soon shift its strategy to maintain price stability. Instead of its traditional two percent annual target for inflation, the Fed will now focus on “average inflation targeting.” In fact, he said, persistently low inflation can bring on a new set of unwanted economic dynamics. Translation: The Fed is going to keep interest rates low for the foreseeable future, even if that means more inflation.

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