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By G. Steven Bray
A recent story in the Financial Times indicated the Federal Reserve is considering a new policy that would encourage higher inflation to make up for periods of low inflation.
The Fed has been frustrated during this recovery by persistently low inflation, lower than its stated target of 2%. This is despite its efforts to prime the economy and expand the money supply and despite record low unemployment, which economic theory suggests should stoke inflation through higher wages.
But super-low inflation sounds good, right? Well, the Fed is concerned that inflation will turn negative, as it has in Japan. Persistently falling prices are a wet blanket on an economy, robbing it of growth, as consumers and businesses postpone purchases in anticipation of lower prices in the future.
So, why should you care? Interest rates primarily have two components. The first component reflects the cost of money, what you pay the lender for the use of its money. The second component reflects expected inflation. Positive inflation means the same amount of money in the future is worth less than it is today.
So, should the Fed announce it’s raising its inflation target, even if the change is not effective, lenders may raise interest rates to account for the possibility of higher future inflation.