Excluding food and energy prices, as economists frequently do when calculating the “core” rate of inflation, the consumer price index in July was 0.1 percent. Inflation for the past 12 months was 1.4 percent, and core inflation was 2.1 percent.
Inflation as measured by the index has been below the Fed’s target of 2 percent annually since April and fell below that level for all but three months between November 2008 and February 2011.
Another measure of inflation known as “personal consumption expenditures,” a measure favored by the Fed, was below 2 percent for all of 2009 and much of 2010 and stands at 1.6 percent as of the second quarter of this year.
The Fed, in short, has been consistently undershooting its inflation target.
Fed policymakers said after their most recent session that they would continue to monitor the economy and consider taking action to stimulate growth at their next meeting, in September, provided there is no sign of inflation. Economists have projected that the Fed might resume buying government and housing debt to help push down interest rates.
Since 1978, the Fed has been tasked by Congress not just with maintaining stable prices but also with keeping unemployment low. The Fed has been even further off its goals there. The Congressional Budget Office has estimated that the “unemployment gap” — the amount that unemployment exceeds the rate expected when the economy is performing normally — was 3.3 percentage points in 2009, 4.3 in 2010 and 3.7 in 2011. If the Fed were hitting its desired unemployment level, that number would be zero.
Some economists — such as Betsey Stevenson of the University of Michigan and Justin Wolfers of the University of Pennsylvania — have argued that the Fed, by continuing to undershoot its own inflation and employment targets, is undermining its credibility while failing to spur an adequate recovery from the recession.
They argue that a bout of inflation could help the economy, at least in the short term. The idea is that inflation makes cash worth less, which spurs consumers and businesses to spend it now before it loses more value. That process could lead to more hiring and growth.
There are a number of ways the Fed could go about allowing higher inflation. One would be to state that the 2 percent target is really a target, not a ceiling, and indicate that Fed policymakers want the rate to rise from 1.4 percent to 2 percent. The Fed would then buy assets until that rise occurs, or simply allow inflation to rise on its own as the markets respond to its announcement. It could also set a still higher inflation target, perhaps 4 percent.
Another option, proposed by Harvard University professor and Mitt Romney campaign adviser Greg Mankiw, would be to change from “rate targeting” to “level targeting.” Under this approach, the Fed would aim for an average annual inflation rate of 2 percent but commit to higher inflation in a given year to make up for low inflation in the previous year, or lower inflation in a given year to make up for high inflation in the previous year. That would allow the bank to react to sudden drops in inflation, like the one that occurred in the last recession, without changing its desired level of inflation.
A more dramatic change would be a move to nominal gross domestic product (NGDP) targeting. Favored by Bentley University economist Scott Sumner and Christina Romer, a former economic adviser to President Obama, this approach calls on the Fed to target a level of annual growth in NGDP, which is the product of inflation and the actual size of the economy. If, as in 2009, real economic growth slows, NGDP targeting recommends inflation to make up for it. If inflation speeds up, it recommends slower growth to correct for that.
These are all approaches that the Fed has thus far resisted. But if inflation stays low and unemployment stays high, the pressure for a change in target is only going to grow.