The Fed’s Case For a Higher Inflation Target

The Federal Reserve has an ammo problem. Inflation may be the only way to solve it.

Participants in the Fed’s meeting last week not only cut their target-rate projections through 2018, they also lowered estimates for where they think rates will be beyond that. Their median “longer-run” projection for rates now centers on 3%, well below the 4.25% offered up in 2012, when the Fed began releasing rate projections.

That means that even if the Fed reaches its goal of 2% inflation and full, not-too-hot, not-too-cold employment, it thinks it will take a lower level of overnight rates to keep the economy stable. It is a reflection of a belief that the neutral rate—the inflation-adjusted overnight rate that is consistent with the economy operating at full potential—has fallen in the years since the financial crisis. That decline could reverse itself if, for example, productivity shifts higher again. But for now, the 3% longer-run overnight-rate projection is consistent with recent Fed research suggesting the long-run level of the neutral rate is now around 1%.

What is worrisome about this is that when recessions have hit in the past, the Fed usually has cut rates by at least 4 percentage points in its efforts to revive the economy. So the Fed’s 3% rate projection is tantamount to an expectation that whenever the next recession comes, the Fed won’t be able to resuscitate the economy with rate cuts alone. Instead, it will have to again resort to tools like quantitative easing which, as recent experience has shown, aren’t as effective.

March 20141.47%

An alternative would be for the Fed to accept more inflation than what it has targeted—not just on a temporary basis, as economists arguing for an overshoot have suggested, but on a lasting basis. Inflation of, say, 3% would allow the Fed to set overnight rates at 4%, providing it with more of a cushion to cut rates when the economy sours.

For investors, a more inflation-tolerant Fed could make low-yielding Treasurys even less appealing, while making stocks relatively more attractive since as consumer prices rise, so do profits. Of course this presupposes that inflation could get to the Fed’s new target before the next recession hit—hardly a sure thing.

Write to Justin Lahart at justin.lahart@wsj.com