Why Does the Fed Care about Inflation?

What does the Federal Reserve have to do with inflation?

Central banks, like the Federal Reserve, are established to foster economic prosperity and social welfare. As with central banks in many other countries, the Federal Reserve has been given more specific objectives by the government, including those related to inflation, to meet these goals.

What is the Federal Reserve's "dual mandate"?

The Federal Reserve is specifically charged by Congress with objectives that were originally established in the Federal Reserve Act of 1913. These objectives were clarified in 1977 by an amendment to the Federal Reserve Act that charged the Federal Reserve "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." The goals of maximum employment and stable prices are often called the "dual mandate."

Does the Federal Reserve have a specific target for inflation?

In January 2012, the Federal Open Market Committee (FOMC)—the Federal Reserve's body that sets national monetary policy—first published its "Statement on Longer-Run Goals and Monetary Policy Strategy." In the statement, the FOMC announced that it believed 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 the Federal Reserve's statutory mandate." Thus, the FOMC's 2 percent PCE inflation objective was born. A number of central banks from all over the world have inflation objectives, and many of them also target an inflation rate of about 2 percent. Inflation rates around these levels are often associated with good economic performance: a higher inflation rate could prevent the public from making accurate longer-term economic and financial decisions and may entail a variety of costs as described above, while a lower rate might make it harder to prevent the economy from falling into deflation should economic conditions become weak.

Publishing a statement on longer-run goals is part of the FOMC’s emphasis on clear communication and transparency. The statement was reaffirmed by the FOMC each year until 2020. In August 2020, the FOMC released a revised statement that describes a new approach to achieving its inflation and employment objectives. The FOMC still views 2 percent inflation over the longer run as its definition of price stability. To reach this longer-term goal and to promote maximum employment, the FOMC indicated that it would now seek to achieve inflation that averages 2 percent over time. From a practical standpoint, this means that when inflation has been running persistently below 2 percent, the FOMC will likely aim to achieve inflation moderately above the 2 percent target for some time in order to return the average to 2 percent. This strategy is termed “flexible average inflation targeting,” or FAIT.

Why doesn't the Federal Reserve set an inflation target of 0 percent?

Even though inflation entails a variety of costs for society, most central banks—including the Federal Reserve—do not aim to have zero inflation. Economists tend to focus on two benefits of having a small but positive amount of inflation in an economy. The first benefit of low, positive inflation is that it helps to buffer the economy from falling into deflation, which entails just as many problems as inflation, if not more. The second benefit of a small amount of inflation is that it may improve labor market efficiency by reducing the employers' need to lower workers' nominal wages when economic conditions are weak. This is what is meant by a modest level of inflation serving to "grease the wheels" of the labor market by facilitating real wage cuts.

Does the Fed focus on underlying inflation because it doesn't care about certain price changes?

Monetary policymakers typically devote considerable time to discussing measures of underlying inflation, and that attention is sometimes interpreted as a lack of awareness or concern on their part with certain price changes, such as those of food or energy. But policymakers are concerned with all price changes, and they look at a large number of indicators when deciding on what actions to take to meet their objectives.

For policymakers of the Federal Reserve, it is important to recognize that measures of underlying inflation serve as a guide for the conduct of policy and not as an objective of policy. One of the objectives of monetary policy is 2 percent total inflation as measured by the PCE price index, and this objective includes food and energy. But when deciding what actions to take to meet this objective, policymakers need to understand which prices changes are likely to be short-lived and which are likely to persist in order to choose the appropriate policy actions. Measures of underlying inflation provide policymakers with insights into which movements in aggregate inflation are likely to be transitory and thereby help them to undertake the actions best suited to achieve desired outcomes.