Decoding the Fed's "Long-Term" Riddle

Written By Luke Burgess

Posted July 12, 2023

The most recent June jobs report showed us that while the job market still seems pretty strong, there are signs of things slowing down.

In June, the job market added 209,000 jobs. Yet this was below analysts expectation and the smallest increase since December 2020.

Despite fresh signs of a slowing jobs market, most traders think that the Federal Reserve will raise interest rates a little bit at its meeting this week.

As of Tuesday, the CME FedWatch Tool shows a 95% probability of a 0.25-point hike.

Economists are expecting an annual 3.1% inflation increase in July. This is a bit lower than the 4% increase in May.

It’s a positive sign for the economy that inflation is getting closer to the Fed’s long-term 2% goal. But it’s important to remember the Fed’s 2% is a “long-term” goal. That means even if inflation fell to 2% in July, the Fed would still have work to do.

The problem is, there’s no way for us to know exactly how much more would need to be done. Let me explain…

The Federal Reserve basically has two jobs: to make sure there are as many jobs as possible and to keep prices stable.

To do the second job, it wants to keep annual inflation around 2%.

The Federal Reserve wants to keep inflation at 2% because it helps the economy stay stable and grow in a good way. This level of inflation helps avoid prices going down too much, which can make people not want to spend money and slow down the economy.

How so?

Well, when prices go down, people might wait to buy things because they think prices will be even lower in the future.

Let’s say you live in a country with an economy where there is gradual deflation over time, instead of inflation — that is, prices decrease over time, rather than increase. And now you’re looking to buy a house. The average price of a house in this reality is $500,000. But since you live in an economy with deflation, the house will cost 2% less in 12 months. Do you buy today or wait 12 months?

Now let’s say you’re looking to buy something more discretionary, like a boat or jewelry or furniture or any of the billion other discretionary items we buy. It’s kind of dystopian if you think about it too hard, but motivating people to consume with inflationary pressures has been a key feature in America’s economic success.

But of course, inflation can’t soar out of control. By aiming for a modest increase of 2% in prices, the Federal Reserve wants to make sure prices stay stable and people feel good about buying things.

Keeping inflation at 2% also helps the Federal Reserve make decisions about interest rates, which are important for borrowing money and investing. When inflation is low, the Federal Reserve can lower interest rates to encourage borrowing and investment, which can help the economy grow. On the other hand, if inflation is too high, the Federal Reserve can raise interest rates to slow down the economy and prevent problems.

Having a moderate level of inflation can help the economy because it encourages people to spend money. But it also encourages businesses to invest. When businesses expect prices to go up a little bit, they're more likely to buy things now instead of waiting. This can help businesses grow and lead to a healthier overall economy.

Lastly, having a clear target for inflation helps everyone understand what to expect and make better decisions. When businesses and investors know what the Federal Reserve wants, they can plan for the future more effectively. This helps the market work better because everyone can make choices based on the same information.

The Fed’s 2% long-term inflation goal is all well and good, but here’s the problem: No one knows what the Fed means by “long term” — in fact, the Fed doesn’t even know.

As far as I can tell, the Federal Reserve does not have a set definition for how long "long-term" is when it comes to inflation. And that’s a problem.

What does it mean? Five years? Ten years? Twenty years? 

It matters a lot.

The average annual inflation rate over the five years between 2017 and 2022 was 3.86%. But if we look over the past 10 years between 2012 and 2022, we find the average annual inflation rate is 2.79%, which is closer to the Fed's goal. If we go back 20 years, from 2002–2022, the average annual inflation rate goes back up to 3.10%.

My point is depending on what the Fed actually means by "long term" should be a guide to its policy decisions. But without that standard definition, I’m not even sure how the Fed justifies its rate decisions. If we consider 12 years specifically to be “long term,” the average annual inflation rate was 2.18% from 20152022. By that measure, the Fed has very little to do.

I’m sure you can see the problem.

On one hand, not having a set definition of "long term" gives the Fed flexibility to change its plans based on what's happening. On the other hand, investors rely on clear guidelines and expectations to make informed decisions. The ambiguity of what the Fed means by “long term” can complicate investment planning, making it challenging to assess the potential risks and returns accurately.

Moreover, it calls into question how the Fed justifies decisions, which is undermining to confidence. it's looking at and planning for the “long term,” but it doesn't give any good explanation of what that means.

I think that having a clear definition for “long term” is best for investors so we can understand the Federal Reserve's plans. If you agree, tweet this article to the Fed with the hashtag #OpenFed and let them know that it's important to be clear about their "long-term" meaning.