In a healthy economy, prices tend to go up – a process called inflation.
While you might not like that as a consumer, moderate price growth is a sign of a growing economy. And, historically at least, wages tend to go up at about the same pace during periods of inflation.
But right now, the U.S. economy is far from healthy and inflation has been relatively subdued in recent years, which can hurt growth. This has prompted the Federal Reserve to pledge to keep interest rates at basically zero until at least through 2023 and try to spur inflation by allowing it to rise above the 2% it targets for the economy.
Getting inflation just right, neither too low nor too high, will be very tricky.
A moderate amount of inflation is generally considered to be a sign of a healthy economy, because as the economy grows, demand for stuff increases. This increase in demand pushes prices a little higher as suppliers try to create more of the things that consumers and businesses want to buy. Workers benefit because of an increase in demand for labor, and wages usually increase.
But when inflation is too low – or too high – a vicious cycle can take its place.
Very low inflation usually signals demand for goods and services is lower than it should be, and this tends to slow economic growth and depress wages. This low demand can even lead to a recession with increases in unemployment.
Deflation, or falling prices, is particularly bad. When prices are decreasing, consumers will delay purchases.
Deflation also discourages lending because it leads to lower interest rates. Lenders typically don’t want to lend money at rates that give them a very small return.
Getting the balance right isn’t easy. Too much inflation can cause the same problems as low inflation.
If left unchecked, inflation could spike, which would likely cause the economy to slow down quickly and unemployment to increase. The combination of rising inflation and unemployment is called “stagflation,” and is feared by economists and central bankers.
It’s what can cause an economic boom to suddenly turn to bust as Americans saw in the late 1970s. The Fed managed to reduce inflation only after driving up short-term interest rates to a record 20% in 1979.
So the Fed has to tread carefully now.
Its new policy allowing inflation to rise higher than its 2% target should allow it to strengthen the economy for a longer period and avoid raising rates too soon. But there’s a risk. If inflation rises too much above the target, it could spiral out of control.
Fortunately, the Fed is typically very cautious, and although it expects to keep rates at zero through 2023, raising them is well within its powers if inflation does get out of hand before then.
Richard S. Warr is a professor of finance from North Carolina State University. Distributed by The Associated Press.
