Question

SOURCE: Nick Timiraos: “Fed Embarks on a Rethink of Its Inflation Target” , Feb. 24, 2019, the Wall Street Journal (Eastern Edition)

Question: According to the article, “Fed Embarks on a Rethink of Its Inflation Target”, Federal reserve officials are considering whether to allow inflation to rise above their 2% target.

1. What is their rationale for letting inflation rate rise above 2%?

2. What will this rise in inflation rate do to the Foreign Exchange Market?

3. What impact will this have on the USD?

Answer 1

1) The rationale that Fed is giving is that if inflation is low, then interest rates would also remain low. Then in the case of a recession, Fed will have little headroom to reduce rates and as such could lead to very limited actions by the Fed. So in order to build enough capacity during the economic expansion, Fed is thinking about letting inflation cross 2% so that interest rates could also rise higher.

2) The rise in inflation, if significantly higher than US's trading partners could impact the value of the dollar vis-a-vis other currencies and could lead to a depreciation in the value of the US dollar.

3) As stated above, a higher inflation in the USA as compared to its major trading partners might lead to a depreciation in the value of the dollar.