Will the Federal Reserve hit its 2% inflation mark?

The Federal Reserve (Fed) has two important goals – to keep unemployment low and prices stable. They estimate that 2% for the Personal Consumption Expenditure (PCE) price index over the long run is the most favorable rate of inflation to support its price stability mandate.

Although achievement of both of the Feds major goals is ideal it is also challenging. The biggest issue for the Fed is that generally, throughout history, there has been an inverse relationship between the rate of inflation and employment. If the unemployment rate is too low, the rate of inflation would tend to increase, and vice versa. This relationship is what is normally called the Phillips Curve, seen below.

This relationship, however, has broken down over the last several decades. During the pre-COVID-19 pandemic years, the US was able to keep inflation under the 2% target while keeping the rate of unemployment at uncharacteristically low levels compared to the historical Phillips Curve relationship. Thus, the questions for the Fed today is whether we will go back to a pre-pandemic relationship between inflation and unemployment or if the Phillips Curve relationship will apply once again.

Over the last two years, inflation has increased to the highest level in 40 years. Consequences of the pandemic such as product shortages, supply chain disruptions, highly expansive fiscal policy, and strong consumer demand played a large role in creating the high inflation we are experiencing. Once all of the above return to more normal levels, inflation should return to the Fed’s long-term target. Although the labor force participation rate overall collapsed during the COVID-19 pan­demic, the recent improvement in labor force participation will help normalize the U.S. labor market going forward.

The bottom line is that the rate of inflation, after remaining below the Fed’s 2% target for several years, has remained above target due to the severe COVID-19 pandemic shock and the aftermath of related policies. Although the Fed was caught off guard and reacted late to its inflationary impacts, the disinflationary process started in July 2022 and has continued ever since.

It is true that inflation has remained above target for more than two years and thus will take longer bring down, but the Fed is committed to achieving its 2% target and it appears not to be a question of “if”, but instead a question of “when”.

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