Inflation: the Fed adjusts its target

Inflation- the Fed adjusts its target

September 17th, 2020

Global stock markets plunged Thursday, following the U.S. Federal Reserve’s announcement that its key interest rate will remain near zero until at least 2023.

London, Paris and Frankfurt lost between 0.7% and 0.8% early in the session. In New York, before the markets opened, the Dow Jones Industrial Average lost 1% and the S&P 500 Broad Market Index 1.2%. In Asia, the Nikkei 225 slipped by 0.7% in Tokyo, the Shanghai stock exchange by 0.4% and the Hang Seng by 1.6% in Hong Kong. The South Korean Kospi and the Australian stock exchange lost 1.2%. On the New York Commodity Exchange, the price of crude oil fell by 24 US cents to US$39.92 per barrel.

The U.S. Federal Reserve adjusted its inflation target to allow annual price increases above 2.0%, a measure that will likely keep interest rates low for years to come.

On Wednesday, the Fed also left its short-term policy rate unchanged at near zero, where it has been since the pandemic intensified in March. Fed officials also indicated in a series of economic projections that they expect the policy rate to remain at its current level at least until 2023.

The Fed’s policy rate affects the cost of borrowing for homebuyers, credit card users and businesses.

According to a statement released Wednesday by the Fed, since inflation has largely fallen below its 2.0 percent target in recent years, Fed policymakers “will now aim to achieve inflation moderately above 2.0 percent for some time. The central bank also indicated that it would leave rates at their low levels until average inflation reaches 2.0 per cent over an indefinite period of time.

The change is important to the central bank because it means that Fed officials will tolerate higher inflation to compensate for its earlier declines below 2.0 per cent. In the past, the Fed ignored these shortcomings.

Fed Chairman Jerome Powell first indicated last month that the Fed would seek inflation above 2.0% over time, rather than maintain it as a static target.

This change reflects the Fed’s growing concern that during recessions, inflation often falls well below 2.0%, but does not return to that level when the economy recovers. Over time, this means that, on average, inflation is moving away from the central bank’s target. As businesses and consumers expect inflation to get lower and lower, they act in such a way that price increases are slower.

The Fed prefers to have some inflation since this gives the central bank more latitude to reduce or increase short-term interest rates.

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