A New Inflation Target of 3-4%

In today’s article I want to discuss the possibility of the Federal Reserve switching the inflation target from 2%. I began reading about this last year and to me it looks like a possibility this year. In this post, I want to discuss why this might happen and what this means.

But why might this happen?

There are a few reasons. 

The first is the supply side. The Fed’s lowering of interest rates can only really affect the demand side. We’ve already seen supply issues happen in with the war in Ukraine and also with shutdowns in China too. There were obviously many supply issues before this during COVID as well. To sum up, the Federal Reserve might decide that squeezing down to 2% is too risky for the US economy.

There are factors at play here too. The Federal reserve might be persuaded to cut rates prematurely due to political pressures. With a huge election in November 2024, there will surely be pressure to try and make the economy look as rosy as possible.

Another reason that we might settle for a 3-4% inflation target is that we might begin to enter into a deep recession. In this type of scenario, unemployment might shoot up drastically or even have an unexpected jump, consumer spending might drop suddenly (Is the US in a silent recession?), and the Fed might cave and decide that 3-4% needs to be the norm for a while. They might come out and say that they are giving up the fight for a while until the economy rebounds. 

Another reason is onshoring. They say that global trade was a big reason that inflation has been low the last 20-30 years. I say it had to do with technological advancement we experienced in the United States. This allowed workers, on average, to become more productive with the creation of things like email, instant messaging and skype. Another reason that inflation has been low is that real wages haven’t kept up with the cost of living.

We can expect onshoring to raise prices for many goods. However, this isn’t all bad as the quality of the items will most likely last longer if Made in the US compared to US. Still, it will make it tougher for the Federal Reserve to hit its 2% target.

How will a 3-4% inflation rate affect you? 

To me the most obvious problem with a 3-4 inflation rate is that it will hurt the average joe and jane. Every year as inflation rises 3-4 percent, we can expect real wages to keep dropping. Cars, homes and many items will become out of reach for most people. Many people will argue that asset prices will have to drop if prices keep going up and there is no one buying them. However, that’s not necessarily true. I expect that people will be forced to take on more and more debt (Read here about 40-year mortgages coming soon). For example, someone might not be able to afford a $400,000 home with a 30-year term. The payment might be too high for the individual. However, if the term is extended out to 40 years, it might allow this same individual to buy the home. In this scenario, responsible savers are hurt even more as they are unwilling to take on more debt.

How will this affect your investments?

Simply stated: real returns become harder to get.

For example, if I make a 4% return on my investment in a year with a 4% inflation rate, I earn nothing.

How does the reserve requirement relate to this?

What’s troubling about this and making matters worse right now is the reserve requirement for commercial banks. The Reserve requirement is the amount of money(deposits) the Federal Reserve requires a bank to hold (expressed as a percentage). For example, with a 10% requirement, if I deposit $1,000 in the bank, the bank must keep $100 on hand. The other $900 can be used for loans. In March 2020, the reserve requirement was lowered to 0% for all banks. Today, in our economy there is still no reserve requirement, although allegedly the economy is in great shape.

This 0% requirement is a reason why getting a positive real return has been so tough. For example, many banks still don’t offer attractive rates on savings accounts because they simply don’t need the deposits. If a bank needs more deposits, they will naturally offer higher rates to try and bring in deposits.