Cecil Bohanon and John Horowitz: The Fed needs to stay the course to fight inflation

The U.S. Bureau of Labor Statistics reported that the year-to-year increase in the consumer price index fell last year from a high of 9.0% in June to 6.5% in December.

This is good economic news because this is the sixth consecutive month the year-to-year rate has declined. The Federal Reserve’s policy of raising the target federal funds rate seven times since March 2022 is working to reduce inflation. Although economic trends are never as predictable as Newtonian physics, the economic data confirms that the Fed’s general approach is effective. It is also reassuring that the national unemployment rate remains below 4.0%, falling to 3.5% in December. We hope this news puts to rest calls for national price controls and other measures to combat inflation.

Will this current reduction in the rate of inflation cause the Federal Reserve to slow rate increases in 2023? Perhaps, but our opinion is that the Fed needs to stay the course to get to a long-term inflation rate of 2%. Staying the course is similar to patients continuing their treatment and taking their medications. However, patients often fail to fill prescriptions, skip taking medicine, or take less than the prescribed dose, which can cause the condition to get worse or harder to treat.

In a perfect world, long-term absolute price stability is desirable. It would be a boon to economic activity if we could expect that goods and services costing $100 in 2023 will cost $100 in 2073. However, for numerous reasons, policymakers find this untenable.

The next-best option is to target a low, positive, steady inflation rate. The Federal Reserve has more or less committed to a 2% inflation target rate in its communications over the last decade. Some have suggested increasing the inflation rate target to 3% or 4%, but raising the inflation target is similar to patients deciding not to continue taking their medications because they fear the side effects or the cost of treatment. If the Fed can change its mind now, what assurance is there that 3%-4% does not become 5%-6% or 7%-8%?

Finally, the 2% target looks doable, and financial markets expect it. The difference in nominal yield between five-year indexed and unindexed Treasury bonds is a well-regarded measure of expected inflation. It stood at 2.20% on Jan. 13, down from its high of 3.59% on March 25, 2022. It is not prudent to change course now.•

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Bohanon and Horowitz are professors of economics at Ball State University. Send comments to ibjedit@ibj.com.

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One thought on “Cecil Bohanon and John Horowitz: The Fed needs to stay the course to fight inflation

  1. “Finally, the 2% target looks doable, and financial markets expect it.”

    You have to love this statement, every 50 years the the current value of the dollar is worth zero. At the current rate of 9%, the current value of the dollar is worth zero in 11 years.

    Maybe we should elect Representative that do not over spend there credit card limit (I.E. raising the debt limit) that mandates the Federal Reserve to to infuse more fiat dollars into the economy.

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