EC The Fed’s Definition Of Price Stability Is Likely Different Than Yours

The Federal Reserve Act, as mandated by Congress, established a dual mandate of price stability and maximizing employment to guide the Federal Reserve (Fed) in setting monetary policy. Price stability, the topic of this article, allows investors, corporations, and consumers the ability to better predict future prices and optimally allocate their investments and spending. The benefits pay dividends not only to those directly involved but importantly to the health of the economy and prosperity of the populace as well.

To consider why price stability is important, consider an oil producer deciding whether or not to invest in a new well. To simplify, assume the producer needs only to consider three variables to properly evaluate the project: (A) investment costs (fixed/variable), (B) a reliable estimate of the amount of oil that may be extracted, and (C) the future price of oil. If the expected return (B x C / A) projects a return above their bogey they might go ahead with the project. The company has reasonable control over investment costs and comfort around their surveying methods to determine the well’s success. Missing, however, is that they have no control over the price of oil in the future. Therefore, the more stable and predictable the future price of oil, the more confidence the producer will have regarding achieving the expected return and the decision about a new well.

As laid out in the above scenario, the Fed’s price stability objective appears to be constructive for people tasked with making investment decisions. The problem we raise here is not the objective, but how the Fed defines “price stability.” Currently, the Fed believes that their mandate to maintain “price stability” would be met if prices, as measured by the Core Personal Consumption Expenditures deflator (Core PCE- Fed’s preferred inflation gauge), were to increase at a rate of 2% per year.

That mandate, as they define it above, is assumed reasonable and to our knowledge has never been challenged in congressional testimony, Fed press conference or during a question-answer session following a speech.

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Author: Travis Esquivel

Travis Esquivel is an engineer, passionate soccer player and full-time dad. He enjoys writing about innovation and technology from time to time.

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