Asked & Answered: Why Not Target Zero Inflation?

Douglas from Detroit, MI:

Why does the Federal Reserve target 2% inflation?  Why not target zero inflation?

Friedenthal Financial:

Douglas,

That’s a great question, without a purely objective and scientific answer.  However, the most elegant explanation of which we are aware is as follows.

Historical evidence suggests that an economy suffers during periods of high inflation.  Generally this is because the local currency is devalued relative to foreign currencies (those with lower inflation).  A lack of predictability of the future currency value creates instability and in some cases panic, which perpetuates economic distress.  These negative circumstances do NOT historically appear present in periods of “low” but positive inflation, such as 2%.

The reason “low” levels of inflation are deemed to actually be desirable in an economy (at least in a capitalist economy) is that it promotes investment.  If inflation is non-existent (zero inflation) there is much less impetus for investors to buy stocks and bonds.  When inflation is running at say 2%, it is hard to hold large sums of cash, which are essentially devalued by the decreased purchasing power of inflation.  So, some positive inflation rate actually stimulates investors to put money into stocks and bonds, which is used to grow business and thus the economy, without having the detrimental effect of high inflation levels.  That said, economists may disagree on the ideal level of inflation.

There is another benefit to targeting a positive level of inflation.  The Federal Reserve can actually set short term rates deliberately BELOW inflation, which gives them more control when it comes to simulating the economy.  As in today’s environment, not only do investors have a disincentive to hold cash (under the mattress), but there is also a disincentive to buy short term government fixed income instruments as well.  This further promotes longer term investment of capital (corporate bonds or equity).  

We hope that helps and provides fodder for discussion. Please let us know if we can be of further service!

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