Government Lending

Fed considers raising inflation target, which could lead to higher interest rates

Key mortgage-rate driver could be moving higher

Low inflation has been a key component of the cheap mortgage rates that have supported the housing market this year. Now, the Federal Reserve is considering a policy change that could result in higher inflation and higher interest rates.

As part of its yearlong review of monetary policy tools, the Fed is considering a promise to respond to sub-par inflation by boosting its inflation target, currently set at 2%, according to a Financial Times story on Monday citing current and former Fed policymakers.

“The central bank is considering a promise that when it misses its inflation target, it will then temporarily raise that target, to make up for lost inflation,” the story said. “The idea would be to avoid entrenching low U.S. price growth which has consistently undershot its goal.”

Fed policymakers are frustrated by the failure of prices to hit their target even with U.S. unemployment near 50-year lows, the story said.

Fed governor Lael Brainard told reporters last week she preferred a more flexible “make up” rule, such as suggesting a target range of 2% to 2.5% inflation after a period of misses.

“That’s a fairly simple thing to communicate to the public,” she said. “It’s very important, obviously, for those rules to work effectively that financial market participants, households and businesses all understand what you’re doing.”

Janet Yellen, former chair of the Fed, said the discussion was “a worthwhile thing” and the policy would be similar to the “forward guidance” the Fed used during the early days of the recovery, when it signaled to markets that it intended to keep short-term interest rates low well into the future, the FT story said.

An explicit make-up strategy would be “more aggressive,” Yellen said. If it were explained to markets effectively, investors would know at the start of a downturn that the Fed was already committed to keeping rates lower for a prolonged period, the FT story said.

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