Why the Fed Wants a Tad More Inflation

For much of the past generation, Federal Reserve officials have been focused on an overarching long-run goal: Get inflation down and keep it there. Now Fed officials want to get inflation a bit higher.

This is more than a little confusing. In a moribund economy that would benefit from more spending by consumers and businesses, is it really helpful to make them pay more for things?

A New Focus

The Fed defeated runaway inflation in the '70s; now it fears that prices are rising too slowly. See a selection of prices that have gone from up to down or flat, and those that are above their long-run trend.

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Economists teach that it is important to push down inflation-adjusted or "real" interest rates—the sticker price on loans minus expected inflation. But what does that mean for consumers and businesses?

In September, the Fed's policy committee said it was prepared to take new steps to invigorate the economy—likely large new purchases of U.S. Treasury bonds. The reason, it explained, is this: "Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability." Huh?

Here's what they are trying to do, and the risks they are taking:

Fed officials generally believe that 2% is a good, not-too-hot, not-too-cold annual rate of inflation. Through the first eight months of the year, it has instead been running at an annual rate just above 1%.

One thing the Fed wants to do is shape business and household expectations so they buy and invest more today. If people expect the price of cars or washing machines to rise, the thinking goes, they will be more likely to borrow and spend now.

Say you're thinking about buying a new car and are offered a loan with a 3% annual interest rate. If you think the price of the car is going to be 5% higher next year, it makes sense to take out the loan and buy it now. It will only cost more in a year. If you think the price of the car won't change, that 3% looks less attractive. The cost of waiting is lower.

"The Fed wants to bring purchases forward in time to increase demand today," said Marvin Goodfriend, a former Richmond Federal Reserve Bank economist now at Carnegie Mellon's Tepper School of Business. Americans have been lectured for years to save more, and they are doing so; the Fed essentially is saying, 'Don't do too much of that right now, please.'

Consumer psychology is tricky to read. Americans have demonstrated a great willingness to go out and buy computers and televisions over the years as they've seen them getting cheaper. The same is true for businesses. "For this to work, of course, businesses have to feel they have something worthwhile to put their funds into," said Kenneth Kuttner, an economist and monetary-policy expert at Williams College.

The Fed sees another reason to want inflation a little higher: To take some burden off of people and businesses with existing debt. Higher inflation tends to go with higher wages, making it easier to pay off fixed-rate loans.

If you took out a fixed-rate mortgage three years ago when you thought wages would keep going up 5% a year, and now discover wages are going up 1% a year, it is harder to pay off that debt.

When inflation gets too low, an economy risks slipping into deflation, or falling wages and prices. That could be especially hard on individuals and businesses carrying heavy debt loads.

One of many reasons Chrysler and General Motors drove themselves to bankruptcy in 2009 was that they couldn't command higher prices for the cars they made, and their profit margins collapsed.

Consumer prices for new cars fell, on average, by 0.4% per year in 2007 and 2008. Chrysler and GM led the way in price discounting.

Some economists argue that the U.S. needs even more than the 2% inflation the Fed says it wants to stir recession-weary households into buying again.

But there are many risks to the Fed's attempt to boost inflation even a little that give officials pause. One is that while helping borrowers, it is making lending unattractive. "In this environment, the question is who is going to be willing to lend to people," Mr. Kuttner said.

Another risk is that the Fed might get inflation in all of the wrong places—such as oil or other imported commodities. That would help exporters of these commodities overseas, but would hurt many U.S. consumers.

In addition, the Fed could end up producing more than the small uptick in inflation it is bargaining for and be forced to drive the economy back into recession with higher interest rates to tame it.

The expectations of households and businesses plays a big role in shaping future inflation. If people come to believe inflation will be a lot higher, it could become a self-fulfilling prophecy. An inflation spiral could make recession-weary businesses even more unlikely to make the investments the economy needs to get going again.

"It seems to me very risky for the Fed to argue that it wants higher inflation," said Mr. Goodfriend. "You're playing with the public's beliefs about the longer run, and you want to do everything you can as a central bank to stabilize beliefs about long-run inflation at a low level."