The Federal Reserve hates near-deflation inflation too. Which is why the Fed hinted that the pace of interest rate hikes will be more gradual than expected.
You may think that you like abnormally low, bottom-of-the-barrel, near-non-existent inflation, but you don’t. Or at least you shouldn’t.
The first thing you have to understand is that inflation—or the general rise in the price of basic goods and services—has been historically low since the financial crisis. Some folks may have a tough time believing that, since the cost of some goods like meat and education, seem to only increase.
Nevertheless, over the last 24 months overall consumer prices have rested at or well below the Federal Reserve’s 2% target. Last month inflation dropped on a year-over-year basis thanks to very cheap oil. If you strip out volatile food and energy prices, inflation only rose at a rate of 1.6%.
So inflation is low. But why is that bad, exactly? Isn’t it a good thing for consumers that prices in general are growing only slightly? Who wants to pay more for things?
In a word: wages. There has been no sustained accelerated income growth for American workers since the Great Recession.
Despite an unprecedented fiscal stimulus effort, despite years of near-zero interest rates, despite three massive rounds of unconventional bond buying to lower long-term interest rates that many economists and politicians wrongly predicted would cause soaring prices, despite a year in which the economy has been adding 200,000 or more jobs a month, there just hasn’t been any meaningful wage growth.
A good metric that illustrates this point is the “employment cost index,” which measures fringe benefits and bonuses in addition to wages. In the last three months of 2014, total compensation grew at rate of 2.3%, or about a full percentage point lower than before the recession. If you look at median hourly wages, you see a similar picture. Workers just haven’t seen meaningful raises in a long time.
This has a harmful effect on the economy. My spending is your income, so if I don’t see more money in my paycheck, chances are neither will you.
The Federal Reserve is clearly concerned about this problem.
The central bank’s most recent economic projections lowered the outlook for core inflation and economic growth in 2015, while simultaneously predicting that the unemployment rate will decline as well.
Which means that the labor market has some more to tighten.
And these worrisome economic indicators are allowing the Fed to be extra cautious about raising rates. “The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run,” the Federal Open Market Committee said in a statement.
If we are in a prolonged period of low-growth, as economists like Paul Krugman and Larry Summers have written, then the Fed should wait until the threat of inflation becomes real before pulling away the punchbowl.
Of course there is a real fear that if you let inflation run, it could quickly get out of hands. Inflation soared by more than 14% in the spring of 1980, while unemployment ran high and the economy ping-ponged between recessions. Then-Fed Chair Paul Volcker dramatically hiked interest rates to tame inflation, which pushed the U.S. into another painful recession just as Janet Yellen was beginning her career as an economist.
The Fed has certainly not rushed to raise interest rates this time, even when the economy blew past certain benchmarks. But there has been a tone that the time is nigh for an interest rate increase despite the lack of inflation. Rates have been very low for a very long time.
Whether it’s this summer or fall or next year, interest rates will eventually rise. (Although as MONEY’s Pat Regnier points out, they won’t rise as much as fast as the Fed originally thought.)
When they do, you should hope that inflation has moved much closer to, or even slightly beyond, the 2% target. The quality of your paycheck may depend on it.