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May 24, 2019, 1:51 p.m. EDT

Why the Fed should ignore calls to cut interest rates because inflation is too low

The Federal Reserve is right to say inflation is on target — when correctly viewed

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By Rex Nutting, MarketWatch

Which one of these indexes is the best measure of underlying inflation? The Fed has traditionally favored the orange line — the core PCE price index — but that gauge has been plagued recently by head fakes caused by one-time price shocks. The blue line — the Dallas Fed’s trimmed-mean index — doesn’t suffer from that flaw.

For the first time in its history, the Federal Reserve is under pressure to cut interest rates not because growth is weak but because inflation is too low.

It seems the closer the Fed gets to achieving its goal of stable consumer prices, the louder the accusations of failure get. From both inside and outside the Fed, the common refrain is that the Fed just can’t do the job — that is, to keep inflation at 2%.

Recently, Chairman Jerome Powell and other Fed policy makers have been explaining (some would call it making excuses) why they are closer to their inflation goal than it looks on the surface.

Contrary to what some think, this is not a case of moving the goal posts .

Increasingly the Fed is relying on alternative measures so it can “look past” transitory factors to judge where inflation is heading over the next year or two.

Research shows Powell and his colleagues are right: There’s no need to cut interest rates to boost inflation, because inflation — correctly viewed — is very close to the target. (Of course, an unexpected slowing in growth would be the more compelling case for lower rates. But that’s another column for another time.)

The Fed’s mandate

First, some background on inflation and the Fed.

By law, the Fed is supposed to achieve and maintain stable prices and maximum employment, but it’s up to the Fed to quantify those goals. For years, both unemployment and inflation were unacceptably high and unacceptably volatile, with negative consequences for the national well-being.

Inflation has been remarkably stable since 1995.

But recently, the Fed has been unusually successful by its own standards, even if unemployment and inflation are both currently a bit lower than the Fed thinks best. Over the expansion of past seven years or so, employment growth has been steady at about 200,000 per month while inflation has been remarkably stable at just under 2%.

You’d think the Fed would be popping Champagne, but there’s a slight problem: Unlike in the 1970s or the 1980s when inflation was much too high (averaging 5.7% over those 20 years), the failure of the Fed today is that inflation is too low, which may seem odd to people who think that the prices they pay should always fall and never rise.

Explaining why a little bit of inflation is actually a good thing is beyond the scope of this column. Instead, I’d like to explain why the Fed isn’t the failure some people think it is.

The Fed is supposed to keep prices stable, but Congress didn’t tell it which prices it should watch, or what stability means. In practice, the Fed has used the consumer price index until 2000 and, more recently, the personal consumption expenditure price index. Those indexes track the prices of thousands of goods and services.

In 2012, the Fed explicitly stated that its goal was 2%, as measured by the PCE index. Since then, year-over-year inflation has been below the 2% target 92% of the time. Transitory, indeed!

From the archives: Why the CPI is not misleading

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