The basic dilemma facing the Federal Reserve is this: Low interest rates promote economic growth but create the risk that the economy will "overheat" with too many dollars chasing too few actual goods and services — causing inflation. Today, the Fed announced it was raising rates for the first time since 2006, signaling that it is starting to worry more about inflation and less about jobs and growth.
The weird thing about this is that the Fed's own forecasts show inflation getting lower, not higher.
Today, as it does every quarter, the Fed released a document showing how the people on the Fed's Open Market Committee — which makes the Fed's interest rate decisions — predict various economic variables will change in the next few years. And the latest projections show something surprising: The Fed's decision-makers have revised their projection for 2016 inflation down. In September, the Fed thought inflation would be 1.7 percent in 2016. Now the central bank thinks it will be just 1.6 percent.
Obviously that's a small difference, but it's also a telling one. The Fed is raising rates because it's worried that keeping rates low for too long will cause inflation to "overshoot," rising significantly above 2 percent and forcing the Fed to raise rates rapidly to keep inflation under control.
Yet the Fed's own actions tell a different story. In September, Fed officials projected that inflation would be only 1.7 percent in 2016, so it kept rates low. Now the Fed thinks that inflation will be even lower — 1.6 percent — in 2016, yet it's raising rates anyway.
This doesn't make sense.
The bus driver's "projections" aren't really projections
Suppose you're riding a bus from Washington, DC, to New York, and you want to know if the bus will stop in Philadelphia. If the passenger next to you says the bus is going to stop in Philadelphia, that's a projection. But if the driver of the bus tells you the bus is going to stop in Philadelphia, it doesn't make sense to call that a projection — the driver is just announcing a decision he's made.
The same point applies to the Fed. The Fed has a ton of influence over future inflation rates, so its "projections" aren't really projections at all; they're statements about the Fed's own priorities. If the Fed raises rates at the same time it "projects" that it's going to miss its inflation target by even more than previously expected, that's a signal that the Fed isn't actually serious about hitting the target.
The Fed has been consistently overestimating inflation rates for several years. At the final meeting of 2012, Fed decision-makers projected that "core" inflation — excluding volatile food and energy prices — would be at least 1.8 percent in 2015. That was revised downward to 1.6 percent in 2013 and 1.5 percent in 2014. Now it looks like core inflation will be 1.3 percent in 2015.
Scott Sumner, an economist at the Mercatus Center, argues that if the Fed is serious about reaching a 2 percent inflation target, it needs to act like it's serious.
"If they could craft a clear statement of what they're trying to do, I think that would help," he says. He argues that if the Fed announced that it won't raise rates again until policymakers are confident that they'll actually hit the 2 percent goal, that would actually boost the economy and help the Fed hit its own target.
Undershooting inflation means undershooting job and wage growth
It might seem like this doesn't matter very much — 1.3 percent isn't that different from 2 percent, and no one likes to see prices go up anyway.
But low rates don't just produce more inflation; they also produce more job and wage growth. Low rates encourage businesses and consumers to borrow and invest, generating more demand for products and services. Companies respond to that demand by hiring more people. As the labor market tightens, employers are forced to offer the employees raises.
That kind of economic boom would be good for almost everyone. The main downside is that it could produce too much inflation. But right now, inflation is at its lowest level in decades, suggesting that the Fed has an opportunity to boost the economy without creating dangerous inflation. And the Fed is blowing it.