Why is the FOMC undershooting its price stability goal?

Market Realist

Is the FOMC achieving its goals? Narayana Kocherlakota weighs in (Part 4 of 8)

(Continued from Part 3)

The FOMC’s goals

The first of the dual goals mandated to the Fed by Congress relates to inflation. Kocherlakota explains that operationally, the FOMC has translated this into keeping the rate of increase of the price level—that is, the inflation rate—close to 2%. Even more specifically, the FOMC uses what’s called the personal consumption expenditure price index (or PCE) to calculate inflation. This measure of inflation captures the rate of increase in prices of all goods and services, including those of food and energy.

The Great Recession is dated as starting in December 2007. The housing bubble, which was a result of Americans with the poorest credit being leant money to purchase houses they couldn’t afford, impacted the U.S. economy badly. Broad market ETFs like the SPDR S&P 500 (SPY) and the iShares S&P 100 (OEF), real estate ETFs like the Vanguard REIT Index ETF (VNQ), and banks like Citigroup Inc. (C) and Bank of America (BAC), all saw their prices slump.

The graph above shows how the PCE price index has behaved over the past several years. Since December 2007, the PCE inflation rate has averaged 1.5% per year. Plus, there has been a downward drift since early 2012. Currently, the PCE inflation rate is running near 1%. So inflation has been running too low over the past six-plus years to be consistent with price stability.

The good news is that the FOMC does expect inflation to turn back toward 2%. However, Kocherlakota expects the return to 2% to take a long time—probably on the order of four years. He recalled that earlier in the year, the Congressional Budget Office had also predicted that inflation will not reach 2% until 2019.

Kocherlakota summed up by saying, “The FOMC is undershooting its price stability goal.”

Continue to Part 5

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