The Federal Reserve Board has resolved to hold interest rates artificially low—as opposed to letting them float with market demand—at least until the economy’s overall inflation rate reaches the Fed’s target rate of 2%.
There are questions concerning whether such a move reduces the Fed’s ability to deal with asset bubbles (whether the Fed should deal with bubbles at all is a separate question) and whether artificially suppressed rates encourage non-market driven levels of risk-taking.
There is, though, a reason why such suppression is simply wrong.
The Fed is (correctly) switching its policy to one of maintaining an inflation band centered on 2%, rather than holding out for a hard 2%.
Interest rates are intrinsically inflationary, though; if the Fed wants to put the economy into that band, it needs to set its benchmark rates at levels that have been historically consistent with a roughly 2% level.
Keeping rates artificially suppressed only removes that intrinsic upward pressure and makes it harder for the economy to reach its target range and stay in it.
There’s always a measurement problem with inflation, too. How do you account for vastly improved products and services, such as go-everywhere comms (cellular) vs. static location only comms (landlines)? How do you compare the price of something completely de novo to measure “price change”? Do you measure the time gained with family due to work from home as a value increase, or a loss in price momentum for transportation? Etc.
That’s one reason why setting an inflation target band is an improvement over setting a hard number. The band gives more time to assess trends in such things–particularly the de novo, and it gives time to assess ways to measure the inflationary impacts of technological improvements on existing overall products–air conditioning as standard in housing, improved engineering vs maintenance in cars, etc.
The band also gives time to ignore such things as noise until the things are better understood.
It doesn’t address other inflation measurement hazinesses, though: a single basket of goods is used at the core of inflation measurements, yet that basket varies across demographic groups, and it/they vary withing groups over time as technology changes, tastes change, and those two feed back into each other.
Eric Hines