The Federal Reserve’s Battle Against Inflation: Why Prices Aren’t Going Down

Key Takeaways

• The Federal Reserve appears poised to cut its key interest rate as inflation slowly falls and the job market steadily worsens.
• The Fed, which is looking for more evidence that inflation is under control, will likely cut the benchmark fed funds rate long before prices start falling.
• The central bank seeks to cool down inflation, but not by so much that prices start going down, since deflation usually goes along with a recession and job losses.

If you’re sick of high prices for the stuff you buy every day, Federal Reserve Chair Jerome Powell has some bad news for you: prices aren’t ever going down—not if he can help it. In his second day of testimony before Congress Wednesday, Powell stuck to the script he laid out the day prior. He once again declined to say exactly when the central bank might cut its influential benchmark interest rate, which is its main tool for controlling inflation. Instead, he explained to the House Finance Committee the Fed’s strategy for fighting price increases while preserving the labor market would crucially include not letting inflation get too low.

Fed’s Goal is to Keep Inflation at About 2%

Powell’s testimony treaded familiar turf but did shed some light on how the Fed is thinking about its battle against rapid price increases. Powell emphasized that the central bank’s goal is to keep prices for the things people buy increasing by an average of 2% per year, not to actually see prices stagnate or go down. To that end, the Fed will likely cut the fed funds rate—putting downward pressure on interest rates for all kinds of loans and stimulating the economy—before inflation has fallen to the 2% goal line.

“You don’t want to wait until inflation gets all the way down to 2% because inflation has a certain momentum,” Powell said in response to a question from Republican representative Mike Flood from Nebraska. “If you waited that long, you’ve probably waited too long, because inflation will be moving downward and will go well below 2%, which we don’t want.”

So What’s the Problem With Prices Going Down?

The exchange highlighted a disconnect between the way experts, economists, and policymakers talk about inflation, and the way most people think about it. The Federal Reserve is tasked with keeping prices stable, which it defines as a 2% annual increase. But what many Americans want after years of inflation running well over that level is for prices to go down. In other words, they want deflation, not disinflation.

A November YouGov poll showed that 64% of U.S. adults wanted “lower prices on goods, services, and gas” as a sign of a good economy. Only 20% wanted higher wages even though pay has just as big an impact on buying power for most households.

So, why can’t we have a little bit of deflation?

While prices for individual items such as gas may rise and fall for benign reasons, widespread price decreases for all kinds of items typically only happen when something has gone horribly wrong with the economy. The only period of sustained deflation since the government started tracking prices happened during the Great Depression.

Why The Fed Fears Deflation

That’s because in the logic of supply and demand in a free market, prices only go down when the supply for things increases, or demand plummets. During a recession, demand falls because people are losing their jobs and no longer have money to spend. Businesses respond to lower demand by laying off workers in what can be a vicious cycle. The Fed aims to avoid this: when unemployment starts to rise, signaling a potential recession, the Fed’s playbook is to cut interest rates, putting more money into the economy and stimulating demand.

And indeed, the labor market is finally weakening as a result of the Fed’s campaign of anti-inflation rate hikes, which began in March 2022. After several months of upticks, the unemployment rate in June stood at 4.1%, the highest since November 2021.

As stress in the labor market mounts, Powell has started to openly question whether it’s time for the Fed to shift from inflation-fighting mode to preventing job losses. According to the central bank’s dual mandate given to it by Congress, it must do both.

“For a long time we’ve had to focus heavily on the inflation mandate, but I think now we’re getting to the place where the labor market is getting pretty much in balance to where it needs to be, and so we’re looking at both,” Powell said Wednesday.

In conclusion, while many Americans may desire lower prices, the Federal Reserve’s primary focus remains on maintaining stable inflation levels to prevent deflation and its associated negative economic impacts. Powell’s recent testimony sheds light on the Fed’s strategy and goals in combating inflation while also considering the state of the labor market. As economic conditions evolve, it will be crucial for policymakers to strike a balance between controlling inflation and safeguarding employment opportunities for Americans.